rjis_15_03

© Research Journal of Internatıonal Studıes - Issue 15 (.August., 2010) 27

An Examination of the Ias 36 ‘‘Assets Impairment’’ on the

Valuation Models Used by Analysts Firms in U.K

Subhan Ullah Lecturer at COMSATS Institute of information Technology Attock Campus, Pakistan

E-mail: [email protected]

Syed Umer Farooq Professor, Kardan Institute of Higher Education, Kabul, Afghanistan


Murtaza Masood Niazi Assistant Professor, Kardan Institute of Higher Education, Kabul, Afghanistan


Abstract The recent global financial crisis has awakened everyone associated with the field of management and accountancy. The importance and attractiveness of accounting numbers (earnings, dividends, and cash flows), which play a significant role in business valuation, is increasing day by day. Equity valuation using accounting numbers is the process of converting accounting forecasts into an estimate of a firm’s equity value. The implementation of this process is carried out by the use of one or more valuation models (Vardavaki and Mylonakis, 2007) including discounted cash flow valuation model, dividend discount models (DDM), and multiple base valuations. Academics generally use the discounted cash flow (DCF) valuation and the residual income valuation model (RIVM). However, analysts prefer to use multiples based valuation (P/E) instead of more complex valuation models like the residual income valuation model (Lie and Lie, 2002).

The paper investigates the impact of IAS 36 ‘assets impairment’ on analysts’ choice and selection of different valuation models. The impact of IAS 36 has been evidenced by comparing brokerage report in pre and post IAS 36 implementation era. It has been found that the impairment test option has widely affected the use of multiple base valuation in two ways; (1) It has abandoned the previous obligatory charge to earnings and (2) it has produced completely different earnings, different multiples, and therefore, different valuations.

Introduction In June, 2001 Financial accounting standard board issued FASB 141 ‘accounting for business combination and FASB 142 ‘Accounting for goodwill and other intangible assets’. FASB 141 eliminates pooling of interest method for combination, while FASB 142 changed goodwill amortization to goodwill impairment. Simillarly, IAS 361 ‘impairment of assets’ which was issued in

1 Other standards relating to Impairment issue: AASB 136 and NZ IAS 36 are issued in Australia and New Zealand

respectively.

© Research Journal of Internatıonal Studıes - Issue 15 (August., 2010) 28

2004 provides detail guidelines for annual impairment testing. Under the new standard, the impairment loss is recorded if the carrying amount of an asset exceeds its recoverable2.

Literature Review There are arguments for and against assets impairment. Barker and Wearing (2001) consider the new rules ‘much favourable’ for intangible economy particularly for British companies. Jennings et al. (2001) examined the impact of goodwill amortization on earnings used in stock valuation. They found that ‘‘amortization add noise to valuation’’. In addition to that, there is a strong association between EBGA (earnings before goodwill amortization) and stock prices, and when earnings based valuation models are used, EBGA explicate more variation of the observed stock price than earnings after goodwill amortization. On the other hand Massoud et al. (2003) exhibit a substantial increase in EPS because elimination of permanent amortization charge to earnings make increase in periodically reported earnings. Furthermore there is a possibility of earnings management as investors can extend the timing of revaluations under the new impairment testing rules (Massoud et al., 2003 and Henning and Shaw, 2004).

Hirchey and Richardson (2003) describe the under-reaction of investors to asset write off. They found that write off (impairment) announcement has a negative effect on company stock price in the scale of -2.94 % to -3.52 %. So far valuation is concerned, there are serious problems related with impairment measurement. The first problem arises regarding the use of a popular model followed by problems in cash flow prediction (Lander and Reinstein., 2003).

IAS 36 does allow the reversal of previously recorded impairment losses which can trigger earnings management. On the part of analysts, it is hard to forecast the times and amount of such unanticipated reversals. In order to avoid such issue, Hùegh-Krohn et al. (2000) recommend that reporting entity must appropriately disclose the possibility of impairment at the time of initial expensing. Doing this, it will result into timely and value relevant information’s for analysts and users of financial statements.

Barth et al. (2001) argue that there is a significant relationship between analyst’s coverage and intangible assets and that a lot of intangibles are not recognized with their fair value can neither be estimated nor disclosed. In such a case intangibles are getting importance because the prices of such intangible firms are less informative and thus misleading if they are not covered or reported by analysts. Barth et al. (2001) hypothesize analyst’s incentive of covering high intangibles. They found that analyst’s coverage is greater in higher R&D and advertising expense firms by attempting to allocate greater time and efforts for high intangible firms.

Research Question The above debate indicates the importance of assets impairment. Researchers have proven that impairment has potential effects on corporate earnings and investors’ reaction. Similarly, IAS 36 requires that goodwill and intangible assets with unlimited life need to be tested for impairment on yearly basis by comparing the ‘carrying amount’ of these assets with their recoverable amount regardless of the fact that there is a possibility that assets may be impaired. The purpose of this study is to examine the impact of IAS 36 impairment of assets on the choice and analysis of valuations models, particularly in the UK high intangible firms.

2 Recoverable amount means the higher of (a) fair value less costs to sell and (b) value in use Picker and Johnson

(1999).


Research Methodology Recent adoption of impairment testing is consistently getting focus from researchers in the accounting paradigm. Investors’ price corporate earnings and the above literature provide a link between impairment and earnings. Although the efficient market hypothesis suggest that share prices reflect all public and private information and nobody can earn excess return, yet investors need reliable and relevant information to make decision. This study examine the pre and post IAS 36 ‘impairment of assets’ effects on the choice, analysis, valuation methodology of the analysts.

The importance of choosing right methodology and research strategy to conduct a research cannot be under estimated as highlighted by Dolin (1998), “it is the methodology adopted by a researcher that has dominant influences on the research process and findings, rather than the methods employed, which remain data collection techniques”. The research methodology of this study is based on Demirakos et al. (2004) paper ‘‘what valuation models do analysts use?’’ Research by Demirakos et al. (2004) exhibit only the use of valuation model in different industries. However, this study will focus on the critical aspects of the valuations models reported by analysts.

Research methods used on the choice of valuation model are not novel to equity valuation. In this regard, Barker (1999) uses a field work method of research. He investigated the behavioural aspects of analyst selection and use of valuations model. The question of ‘why to use a particular model would not be answered by direct approaching to market participants. The unwillingness of analysts firms to answer the choice of valuation model put cap on the validity of fieldwork research in the area of equity valuation. Contrary to Barker (1999), this study analyzes the contents of analysts report and the style of investigation which is consistent with previous research of Bradshaw (2002) and Demirakos et al. (2004).

Hypotheses Development The study examines the aftermath of IAS 36 on analysts forecast, selection of valuation drivers and valuations models. The descriptive part focuses on the critical perspectives of valuation models, while the statistical analysis only compare and test whether there are any cross-sectional variations in analyst valuations due to impairment. The following hypotheses are developed:

:H IAS 36 implementation has no association with the choice of valuation models (Enterprise Value/Earnings before Interest, Tax, Depreciation and Amortization, Enterprise Value / Sales, and Discounted Cash flow Method) across time.

:1H IAS 36 implementation has association with the choice of valuation models (Enterprise Value/Earnings before Interest, Tax, Depreciation and Amortization, Enterprise Value/ Sales, and Discounted Cash flow Method) across time.

Data This research is based on analyst reports available on financial database—InvestText--which contains more than five million articles. Since this study investigates cross-sectional trends, 20 analysts’ reports are selected from 2007 available report and the remaining analysts reports3 are downloaded from InvestText.

3 Analysts report will be produced on request.


Sample Selection Analyst’s reports are selected for those companies having high intangibles on the face of balance sheet. However, to get the results in relative terms, companies having high intangible to total assets are chosen for the purpose of analysis. Since the analysis involve two periods, the problem arise whether the same firm had high intangibles in the prior period. Tangibility of the target companies was examined from world scope and those companies with low intangibility in the prior period were excluded. Furthermore, to extend the generalizability of the findings, analyst’s reports from different investment banks are selected. Besides this, few high ranked intangibles companies were not included as these companies were either new born or they were operating with some other name in 2000. The following table show the number of firms selected firms with different analysts report in two periods. Table I: Showing Sample Firms/ Brokers in Two Sets of Periods Companies Analysts Report for 2000 Analysts Report for 2007 INFORMA HSBC Bank ABN-AMRO SAGE GROUP Deutsche Bank Deutsche Bank JOHNSTON PRESS Deutsche Bank Deutsche Bank MEGGITT HSBC Bank SOCIETE GENERALE RECKITT BENCKISER HSBC Bank SOCIETE GENERALE TRINITY MIRROR Deutsche Bank Deutsche Bank BAE SYSTEMS HSBC Bank Deutsche Bank VODAFONE GROUP Daiwa Institute of Research Europe HSBC Bank DAILY MAIL 'A' HSBC Bank Deutsche Bank LOGICACMG HSBC Bank Deutsche Bank

There can be no question regarding the biasness of the selected sample because sample firms are not confined to few analysts firms. It can be seen from table 1 that the selected sample have different analyst’s reports in two different periods. The existence of such diversity in sample will clearly answer the question: which valuation models are used by analysts in practice and why analysts use a particular model for a given firm/period? Thus the results are expected to have more generalizability. The following table illustrates the descriptive statistics for the sample firms. Selected firms represent six different sectors. Table II: Descriptive Statistics Showing Main Variables

Year 2007 Year 2000

Companies Net Income

Book value of equity

AnalysisFollowing Sector Net

Income

Book value of equity

Sector

INFORMA 99,192 927,851 12.86 Media 20,210 22,817 Media SAGE GROUP 154,100 1,050,800 20.11 Software 74020 7,412,000 Software JOHNSTON PRESS 113,403 682,669 12.80 Publishing 83896 250,733 Publishing MEGGITT 89,300 1,063,400 11.50 Aerospace 64301 231,528 Aerospace RECKITT BENCKISER 938,000 2,383,000 21.20 Household 314,000 3,253,000 Household

TRINITY MIRROR 203,300 851,900 14.00 Publishing 268,323 268,300 Publishing BAE SYSTEMS 879,000 5,966,000 21.17 Defense -34,000 17,313,000 Defense VODAFONE GROUP -4932000 67,067,000 27.11 Mobile 487,000 15,303,900 Mobile DAILY MAIL 'A' 107,000 692,900 9.57 Publishing 110,400 1,845,200 Publishing LOGICACMG 80,500 1,597,000 29.00 Software 82,800 365,900 Software

The study focuses on the valuation models across time particularly after the implementation of

IAS 36. Figure I in appendix B shows that multiple based valuation e.g. EV / EBITDA, EV/ Sale were primarily used in 2000. However, after the implementation of IAS 36 many analysts switched to DCF


based valuation. The table shows operating income and the book value of equity of the selected firms for two different periods4. The mean number of analysts forecast for year 2007 indicates the number of analysts who were following that particular firm. The critical contents analysis and the statistical analysis will answer the question of previously used models compare to current valuation models. Before critically evaluating the contents of brokerage reports along with the model used, it is necessary to briefly define such valuation models. Table III: Definitions of Valuation Models Used in the Brokers Report

Valuation Models Definition

EV/EBITDA

EV/EBITDA is a valuation multiple that is often used in parallel with, or as an alternative to, the P/E ratio. Typically, this ratio is applied when valuing cash-based businesses. Where EV is the enterprise value and EBITDA denotes the earnings before interest, tax, depreciation and amortization.

DCF The discounted cash flow valuation model.All future cash flows are estimated and discounted to give a present value

EV/ Sale A valuation measure that compares the enterprise value of a company to the company's sales. It gives Investors an idea of how much it costs to buy the company sales. Generally the lower the EV/sales to be the more attractive or undervalued the company is believed

The Role of Analysts Reports in Equity Valuation A wide range of empirical research concentrates on analyst reports, its contents and recommendations. Prior research focuses on stock market reaction to analysts’ earnings forecasts or recommendations. Earlier study by Abdel-khalik and Ajinkya (1982) describe that any forecasting revision by analysts had abnormal returns in the publication week. Lloyd-Davies and Canes (1978) find that share prices adjust with analysts’ forecasts and recommendations, and any revision by analysts has effects on stock prices. Womack (1996) investigated the consequences of analysts ‘Buy’ and ‘Sell’ recommendations on stock prices. Hefound that the mean post event drifted for buy recommendations is (+2.4%) and very short while the drift was large (-9.1%) for sell recommendations.

Very recently, Asquith et al. (2005) replicated previous research and analyse 1126 analysts report by 56 analysts and 11 investment banks. They examined whether analysts forecasts, forecasts revision, recommendations and justification had affect on stock prices? They also investigated the market reaction to analysts target price. Asquith et al. (2005) established that analyst’s reports include new information and the market reacts to these new information.

Findings A thorough study of the brokers reports indicate that sophisticated model like RIVM is very limited in practice and it is noted for both sample periods. Such a limited use can be attributed to the very recent introduction of this RIVM relative with the long established DCF model. Also, the high usage of the DCF can be attributed to the fact that it has been extensively taught in finance courses (Demirakos et al., 2004)

The selected companies has different accounting policies which has affected profit multiples for such companies, and the resulting differences in multiples have painted a misleading picture of relative valuation. it has been found that the impairment test option has widely affected the use of multiple base valuation in two ways; (1) such option has abandoned the previous obligatory charge to earnings and (2) it has produced completely different earnings, different multiples and therefore different valuations.

4 Johnston press, Meggitt, Reckit Benckiser, LOGICACMG and Trinity Mirror financial data for year 2000 is taken from

company annual reports. Data for the rest of the companies have been downloaded from Thomson one banker.


In addition to that, it has been discovered from the contents of analysts’ report that EV/EBITDA is widely used by many analysts before IAS 36 implementation. However, the use of EV/EBITDA has not considered significant changes in working capital which is crucial for financial decision making. Similarly, it has been noted that in many cases this method has ignored important capital investments.

In general, the valuations models are not properly explained but the BAE company analyst report (2007) is more comprehensive and it uses sum of parts valuation (SOP). Using the SOP, analysts have used the required methods of valuation for different segments e.g models like; EV/Sales, DCF, EV/EBIT are used for valuing these segments. In such a case the enterprize value has been calculated by adding segment based valuation results.

It must be remembered that a DCF based valuation is used for a BAE project (72-euro fighter saudi deal) bceause it has known and certain cash flows. According to the BAE forecasted financial statements (year 2000 analyst report) the company has large amount of write offs. The amount of such write off in 2000, 2001, and 2002 is twice as the income number reported for that period (as per thomson financial ). The method used (EV/EBITDA) does not take into account such huge number of write-offs which has ultimate effectss on valuations. Previously amortization and other write off (assets impairments) was not value relevant and was not considered in valuation, so any difference in analysts forecasts and possible impairment could not effect the valuation process. As per new rules the impairment of assets is not permanatly and annualy charged to the income statement and it has been to some extent upon the discretion of the management which make it hard to estimate the amount and timing of such write off. The DCF based valuation has added back such write off (amortization, depreciation, impairment) to get the free cash flow, so these significant changes in analysts numbers and the actual amount of write off has effectsed the valuation. It has been observed in BAE 2007 analysts report that difference in analysts forecasts and acual amount of write off was trice and analysts has underestimated the future writeoffs.

In parrallel with EV/EBITDA, many analysts report provides EPS and forecasted P/E multiplesbut at the same time they have not used the P/E multiple in their valuation and recommendation process. The reason for showing such alternative multiple is that the EPS was either low or zero and the use of such low or zero EPS can results into biased valuation. According to analyst report for year 2000 EV/EBITDA was the most frequently used model and one reason of such a higher usage is the leverage effect. In the presence of leverage the use of P/E multiple produce earnings differences between identical firms which distort the P/E multiple. Compared to P/E model the enterprise value multiples are less affected by different capital structure and that is why it has been used to measure the unlevered value of an enterprise.

Another interesting issue related with valuation model is the use of similar model for a set of comparables within industry. Using this approach analysts has estimated a single forecast on national, regional level and there is no need of separate forecast for different firm operating within same industry and region (same forecast for firms with same structure and size).

On the part of DCF, it has been found that analysts use DCF in circumstances where huge cash transaction is involved ( Buy back of £50 million, huge capital expenditures, increasing payout ratio., the case of Daily mail 2007 report). So, applying any other model instead of DCF is meaningless as it will fail to capture value relevant informations. In addition to that, the use of DCF is also triggered by decline in earnings and applying earnings based valuation model results into lower valuation. Another reason for the use of DCF is the existance of leverage beacause interest on debt is benefecial in form of tax shield and the addition of tax adjustment on net interest provides superiority of DCF over EV/ EBITDA which ignore such adjustments which may be material and relevant in valuations.

It has been observed from two sample period that EV/Sale was rarely used because recently researchers have started using sales as a value driver because earnings and cash flow may be negative (Liu et al., 2002). In line with Liu et al. (2002), the analysis shows that EV/Sales was used for those


firms having consistant sales growth, while profit and cash flow were unrepresentative/negative (Informa plc., Analyst Report .,2000).

Statistical Analysis In order to examine the impact of impairment on the application of valuation model the analysis suggest 2χ test. Detail calculations are shown in appendix A. Chi-square results shows that H0 is rejected at 5% significance level (rejection criteria as per appendix A is 6.37> 5.99) which mean that IAS 36 implementation has affected the choice of valuation models (Enterprise value/Earnings before interest, tax, depreciation and amortization, Enterprise value / Sales, and discounted cash flow method) across the time.

The valuation models used in 2000 and 2007 clearly reflect a slowdown in the use of enterprise value model, while an incremental increase in the use of discounted cash flow model is notable, while the reasons of such a change are explained earlier. Chi-square analysis and content analysis of the reports show that the new standard ‘assets impairment’ has affected the selection of models to a greater extent. Summing up, the importance and impact of new standards cannot be completely ignored in valuation Conclusion IAS 36 ‘impairment of assets’ was issued in 2004 which provides detail guidelines for annual impairment testing. IAS 36 also require similar impairment testing procedures for intangibles, therefore this research link the issue of impairment with assets particularly to intangibles. In this study we investigated the effects of IAS 36 on the choice, analysis, and valuation methodology of the analysts.

We found that discounted cash flow method has been used in circumstances where huge cash transaction is involved e.g Buy back of £50 million, huge capital expenditures, increasing payout ratio., the case of (Daily Mail 2007, Analysts report5). This shows the fitness of a particular model for a specific accounting transaction.

The findings of this paper are consistent with the recent working paper of Imam et al. (2008), which investigate the choice of valuation models reported by UK firms. Their research is based on both field work (analysts’ interview) and contents analysis of analysts’ reports. They found that ‘sophisticated’ model like DCF was more significant for analysts and they do rely on ‘unsophisticated’ models like PE multiple. It can be concluded that although literature provides detail advantages of using alternative valuation models, yet analyst’s actual usage of valuation models also requires an understanding of social and economic context and motivations. Future Research The importance of this area is considerably increasing. Investors are getting more sophisticated curious and need sufficient information in the analyst report. Though, the theoretical models can be more complicated but still there is little adoption of complex models. There is a need for future research in this field with major focus is on the field work. Barker (1999) used a field work method of research by investigating the behavioural aspects of analyst’s selection and use of valuations models. Although, access to respondent analysts firm will be a visible hindrance in data collection but researchers and academics have done it in the past. Similarly, it is necessary to investigate the role of corporate governance in equity valuation, because the existence of analyst’s firm’s stake in the target company may effects the opinion of analyst.

5 Analyst’s reports are available at Invest Text, a financial database. Alternatively, these reports can also be traced at http://banker.thomsonib.com



Appendix A. Chi Square Calculations

Actual values as per analysts Report 2000 2007 Row total EV/EBITDA 6 2 8 DCF 3 8 11 EV/Sales 1 0 1 Column 10 10 20

Total 20 20 40

Expected Value 2000 2007 Row total EV/EBITDA 4 4 8 DCF 5.5 5.5 11 EV/Sales 0.5 0.5 1 Column total 10 10 20

The formula of Chi-square is as follow:

∑ −=

E)( 2

2 EOX x

Where O denotes the observed frequency and E denotes the expected values. χ2 = ∑(Actual – Expected Values)2/Expected values

= 1 + 1.14 + 0.5 + 1+ 2.23 + 0.5 = 6.37, At 5 % significance level, χ2

0.05,2 = 5.99 Appendix B. Number of Valuations Models Used


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