New reporting requirements give public companies fresh opportunities to fool investors

Rachel Bradley  by Rachel Bradley
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

“Every man hears only what he understands.” – Goethe

Often, details in the financial statements hold the key to understanding a company. Here at Gradient Analytics, we specialize in forensic accounting research and consulting, and our analysts stay up-to-date on changes in the regulatory landscape, including crucial updates to disclosure requirements. Normally, we focus research on areas that might tempt companies to “manage” or overstate earnings, either by pulling forward future revenues or pushing out current expenses. Layer on more complexity from changing reporting requirements and it becomes clearer how a vital piece to the puzzle might slip through the cracks.

Below, I cover three broad topics. First, effective January 1, 2020, the governing accounting boards updated the very definition of a business. This new definition has multiple implications for reporting, but my focus in this article is the impact on M&A transactions. Moreover, this year both the Financial Accounting Standards board (FASB) and the International Accounting Standards Board (IASB) changed required disclosures for U.S. and international companies. Among other things, there is a new method for determining appropriate loan loss reserves, and there will soon be a requirement for companies to stop using Inter-Bank Offered Rates (IBOR) as reference rates, instead switching to Alternative Reference Rates (ARR). I describe these updates with four real-life examples of how they shape financial statements, with the potential to mislead investors. Read on….

ASC Topic 805 – Is it an acquisition or an asset purchase?

This year, because of updates to ASC 805-Business Combinations, we expect there to be fewer M&A transactions. Certain deals that would previously have been categorized as business combinations will now be considered single asset sales. Since the reporting requirements for an asset purchase are much less than for a business combination, this update reduces investors visibility into affected transactions. Some aspects of the old definition remain unchanged. A business is still a related set of activities capable of generating a return. However, under the revised guidance, the set of activities needs to have an input as well as a substantive process to be a business. Together, the set of activities and process must meaningfully add to a company’s ability to produce outputs. This revision has more rigorous criteria for activities without outputs in order to qualify as a business, as the very existence of outputs suggests evidence of a business.

The FASB released a dual approach test to decide if an input and a substantive process are present. First, it must be determined whether a single asset drives “substantially all” (i.e., around 90%) of the value in a transaction. If so, the buyer can record the transaction as an asset sale. If multiple assets drive value, then the evaluation must move to the second step. If the purchase includes outputs, then one of the following four conditions needs to be met for the purchase to qualify as a business combination: (1) employees perform the process to convert inputs to outputs, (2) a contract gives the firm access to the workforce, (3) the substantive process is irreplaceable, or (4) the substantive process is unique. In contrast, if the purchase does not include outputs, then the set of activities must include both of the following criteria to qualify as a business: (1) a workforce and (2) an input that the workforce can convert into outputs.

This classification is important because there are significantly fewer disclosures required for an asset sale than a business combination. From an earnings quality perspective, firms can dramatically limit investor visibility simply by buying assets one by one, rather than every project that a business has all at once. Another distinction is that goodwill will only apply to a business combination. If the transaction is an asset sale, there will be no value assigned to goodwill and analysts will only assign value to other intangible assets and physical assets.

To illustrate, here is a transaction that shows the new standards in practice. Despite the considerable investment involved, this transaction is considered an asset sale, not a business combination. On 11/21/19, Amgen (AMGN) paid Celgene Corporation $13.4 billion in cash for the drug Otezla and the related assets and liabilities. Otezla, a small molecule that inhibits phosphodiesterase-4 (PDE4), is the only oral treatment for psoriasis and could potentially treat more conditions in the future. Otezla is in phase 3 studies for the treatment of certain oral ulcers, genital psoriasis, and plaque psoriasis. Of the $13.4 billion in net assets bought, almost all the value (98%) was concentrated in developed-product-technology rights. The presumption is that clinical research and manufacturing contracts were at market rates, so management can easily replace them with other vendors. In that case, the purchaser can conclude that there is no fair value assignable to the process. Accordingly, this qualified as an asset sale, with no goodwill reported.

IFRS 3 – The IASB takes its own crack at acquisition vs. asset purchase:

The IASB also recently updated its definition of a business. While the IASB and FASB worded changes to IFRS 3 and ASC 805 differently, the updates are based on similar intentions and should lead to more consistency in reporting. The amendments to IFRS and U.S. GAAP differ in certain respects, as the “concentration test” is optional under IFRS but mandatory under U.S. GAAP. Under IFRS, firms that choose to apply the concentration test and determine that substantially all the fair value is concentrated in a single asset, can record the purchase as an asset sale.

Like GAAP, this amendment addresses whether the acquired set of activities includes a substantive process. This change expands the definition of outputs to include goods or services provided to customers as well as income to investors. Previously, IFRS only defined outputs as returns to investors, like dividends or lower costs. If the purchase includes outputs, then the process is substantive if either of the following conditions are met: (1) the process is critical and inputs include an able workforce, or (2) the process is unique or irreplaceable. In contrast, if the set of activities for sale does not have outputs, then the acquired process will only be substantive if both of the following conditions are met: (1) the process is necessary to convert inputs to outputs, and (2) the acquired inputs include both a workforce and other inputs.

In contrast to the AMGN example, let’s examine a smaller transaction that is nonetheless a business combination. On 12/09/19, Sanofi (SAN) entered an agreement to acquire Synthorx, Inc. for $2.5 billion. SAN is a biotechnology firm based in Paris, France, and reports using IFRS. It completed the acquisition of Synthorx, Inc., a clinical-stage biopharmaceutical company in La Jolla, California, on 01/23/20. Synthorx has yet to report positive earnings and has incurred sizeable losses. This acquisition would not include outputs under the old IFRS definition because there is no income to investors, but under the new standards, products for sale represent outputs even if the firm is loss-making. This purchase includes R&D activities on several drug compounds in development. These are in various stages of FDA approval and would treat a variety of cancers and autoimmune disorders. The purchase includes senior management and scientists who can continue their roles along with long-lived tangible assets like headquarters and research labs. R&D projects can be considered other inputs used in the process. Because this acquisition encompasses a set of activities with a workforce capable of executing processes that are substantive, this is considered a business combination. When SAN submits its next interim filing, it will likely report some added goodwill, which also signifies this transaction as a business combination.

ASC Topic 326 – CECL method replaces actual incurred loss with lifetime expected loss:

Unlike the standard on business combinations discussed above that reduces visibility, this accounting update (effective 01/01/20) requires earlier recognition of credit losses and increases transparency about credit risk. This significantly changes how companies measure credit losses because it introduces the Current Expected Credit Losses (CECL) model. Most of the prior required disclosures are still intact, but the revision expands required reserve disclosures. The determination of the proper allowance for loan loss reserve (ALL) is complex and subjective. Many factors like the economic forecast, expected prepayments, and portfolio mix all impact changes to the provision and reserve. To give scale to this revision, some analysts estimate that increases to reserves in the financial services industry could be between $50 billion—$100 billion (30%-50%).

The new method requires firms to expense more credit losses upfront and replaces the prior “incurred loss” approach with a lifetime “expected loss” model, i.e., CECL. Now firms will recognize all losses expected over the life of a loan upon origination/purchase. While this improves the quality of earnings, companies may choose to circumvent the higher CECL reserve by recognizing instruments at fair value with changes in value reported to earnings on the income statement. However, to continue reporting loans with changes in value kept off the income statement (i.e., rolled up in other comprehensive income), firms will now need to follow the CECL method, which requires a higher reserve. Previously, firms would delay recognizing a loss until it was probable that the firm had already incurred a loss. To implement CECL the first year, firms record a cumulative adjustment to retained earnings for the amount of the change in the ALL.

In the next example, I describe the impact that CECL had on a major bank. Like most banks, Citigroup (C), needs to increase its ALL to be compliant with the new standards. For instance, in its Annual Report (02/21/20), Citigroup said that it expects to increase its ALL by $4.1 billion pretax or 29%, reduce retained earnings by $3.1 billion after tax, and create a $1.0 billion deferred tax asset. On a more granular level, the impact of CECL created a small release of reserves related to Citigroup’s corporate net loan loss exposures. In other words, changes in the reserve from shorter duration commercial loans partially offset the overall increase to the reserve from longer duration consumer loans.

Furthermore, not only does CECL impact banks’ reserves, but it also affects capital ratios. At adoption, firms can choose to phase in the impact of adopting the new standard for regulatory capital adequacy purposes, which Citigroup did. The phasing in allows firms to only include one-fourth of CECL's capital effects per year. Accordingly, Citigroup’s “day one” capital effects from changing to CECL commenced phase-in on 01/01/20 and will be fully reflected in capital on 01/01/23. Citigroup estimated that adopting the CECL method ultimately will reduce the common equity tier 1 capital ratio by a total of 25 bps or about 6 bps per year.

As another example of the impact of the new standard, consider a firm that also increased its ALL in response to implementing CECL, but by a lower amount because it chose the fair value option for some loans. When Goldman Sachs (GS) adopted ASC 326, the cumulative effect was a $640.0 million after-tax decrease to retained earnings. GS expects to increase its ALL by $848.0 million from implementing CECL. However, the firm also changed the classification of loans that were previously accounted for as Purchased Credit Impaired (PCI) and chose the fair value option. This decreased the allowance for PCI loans by $169.0 million. Even though the net impact (close to $679.0 million pretax) to ALL was a 47% increase, had the firm not chosen the fair value method for PCI loans, the increase in reserves would have been even greater.

Firms must transition away from LIBOR soon:

Starting as early as next year, firms will need to transition from commonly used Interbank Offered Rates (IBORs) to Alternative Reference Rates (ARRs). In particular, companies that have long used the London Interbank Offered Rate (LIBOR) must choose a replacement rate, which may not come as a surprise as LIBOR has been the subject of prior manipulation. This will be critical for firms that heavily use IBOR-based financial products. To give this issue scale, the JPMorgan Chase (JPM) Annual Report filed on 02/25/20 estimated that $400 trillion of global transactions reference IBORs. Regulatory boards in the U.S. and the U.K. are actively engaged, asking companies to reduce exposure now to ensure a smooth transition. Both the FASB and the IASB issued updates to accounting standards to help firms prepare for the coming deadline.

On 07/12/19, the SEC released a statement that said many firms will stop using LIBOR as a reference rate in 2021 and gave firms guidance on steps to take now, so there will be minimal disruption to the financial markets. The statement also discusses how firms need to stay cognizant of upcoming changes on a global scale. Countries are in various phases of the decision process for choosing replacement rates, so this is still an evolving landscape. Not only did the SEC encourage firms to immediately reduce exposure, it also said that firms should increase disclosures to investors describing current exposure, where the firm is in the process of transitioning, and any other related risks.

Internationally, the U.K. Financial Conduct Authority (FCA) also questioned the future of IBORs. In fact, the FCA got voluntary bank support to only sustain LIBOR until 2021. As such, we expect that firms will not be able to use LIBOR (both in the U.S. and internationally) by 01/01/22. Despite this, a recent survey from The International Swaps and Derivatives Association (ISDA) showed that there is a gap between awareness and action on this issue. Many firms have yet to reduce their exposure or give investors any details. Based on current updates from governing authorities on the matter, firms must start acting now as kicking the can down the road will create more cost and complexity when those firms eventually do change to a new ARR.

In summary:

Both domestic and international firms are now operating under significant new requirements, including a revised definition of what constitutes a business versus a single asset, a new loan loss provisioning method, and a mandated shift away from IBORs. Clearly understanding these kinds of details is particularly important to accurately interpret information communicated through financial statements. A firm facing unexpected headwinds and having difficulty meeting its performance goals likely will not announce this in the headline of a press release or provide a lengthy discussion about it on a conference call. Instead, it is more probable that the firm will take advantage of changes in the regulatory landscape to obfuscate the economic health of the firm.

As such, Gradient Analytics’ analyst team will continue to vigilantly alert our clients of critical updates and uncover opportunities that corporate executives may exploit to present a perspective of the company that appears much healthier than the true economic health of the underlying business. Our buyside clients use this information to either support their thesis of the company as a possible short candidate or to avoid a hazardous long position. Stay tuned for more to come in future updates!

Disclosure: At the time of this writing, the author held no positions in the securities mentioned.

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any opinions, commentary, rankings, or stock selections provided by Sabrient Systems or its wholly owned subsidiary Gradient Analytics. Sabrient Systems makes no representations that the techniques used in its rankings or analysis will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.


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