Thursday, January 26, 2012

Why S&P has downgraded French Banks

On January 23, 2011, S&P has announced to downgrade major French Banks, including BPCE, Crédit Agricole, and Société Générale, from A+ to A. BNP’s rating remained at AA- but was, nevertheless, put on negative outlook.

In the following, I explain S&P’s rationales for the above mentioned announcements as well as how S&P develops its decision, based on its rating methodology for banks.







The above schema shows S&P’s decision-making process as it is described in its rating methodology for banks dated November 9, 2011.

1st line of thought (blue circle) – France’s BICRA score

The BICRA (= Banking Industry Country Risk Assessment) score combines the appreciations of France’s economic and industry risk. This score and, therefore, France’s anchor SACP, remains stable at a-. The reason for this is that France’s downgrade from AAA to AA+, on January 13, 2012, was linked exclusively to “the impact of deepening political, financial, and monetary problems within the euro-zone”; in S&P’s view and from a pure French point of view, the appreciation of its economic and industry risk remains unaffected.

2nd line of thought (yellow circle) – French banks SACP

For all above cited banks, the SACP (= stand alone credit profile) remains unaffected. Naturally, the reasoning varies from one bank to another.

  • BPCE, Crédit Agricole, and Société Générale are seen to have a “strong business position, moderate capital and earnings, adequate risk position, average funding, and adequate liquidity”. Their SACP is a-.
  • BNP is seen to have a “very strong business position, moderate capital and earnings, strong risk position, average funding, and adequate liquidity”. Its SACP is a+.

3rd line of thought (green circle) – Rating uplift / down-lift due to the likelihood of government’s support

S&P applies a 2 step process to motive the rating downgrade of BPCE, Crédit Agricole, and Société Générale as well as the rating confirmation in case of BNP.

First, it evaluates the systemic importance of the specific bank in combination with the French government’s tendency to support private-sector commercial banks:

  • The French government is seen to be “supportive” of its banking sector.
  • BNP, BPCE, Crédit Agricole, and Société Générale have a “high systemic importance”.

Second, applying predefined tables that combine the above findings with France’s new AA+ rating, S&P concludes mechanically that

  • BPCE’s, Crédit Agricole’s, and Société Générale’s indicative ICR are A.
  • BNP’s indicative ICR is AA-.



The French government is seen to be “supportive” of its banking sector.
BPCE, Crédit Agricole, and Société Générale have a “high systemic importance”.

You can find more detailed explanations on S&P’s decision making process and rating methodology for banks here.


References:

  • S&P Announcement on France’s BICRA dated January 23, 2012
  • S&P Research Update on BNP dated January 23, 2012
  • S&P Research Update on BPCE dated January 23, 2012
  • S&P Research Update on Crédit Agricole dated January 23, 2012
  • S&P Research Update on Société Générale dated January 23, 2012
  • S&P Rating Methodology and Assumption – Banks dated November 9, 2011

Saturday, January 21, 2012

Accounting Conservatism under IFRS

A few weeks ago, I have written about accounting conservatism under GAAP and its impact on future probability of the firm. Today, I would like to continue this discussion by presenting the structure of IFRS general principles and, in particular, the position of accounting conservatism among such general principles.

Under the IFRS Conceptual Framework for Financial Reporting, issued by the IASB in September 2010, the overall goal of financial information is to be useful to existing and potential investors. Chapter 3 of the conceptual framework describes the qualitative characteristics of the information as is summarized in the following schema:




As opposed to the 1989 Framework for the Preparation of Financial Information, the principle of accounting conservatism does not constitute a qualitative characteristic under the new 2010 framework.

Does this mean that its application is no more appropriate under IFRS? In my view, this question should be answered in the negative. As the “purpose and status” description of the 2010 framework points out, “nothing in [the 2010] Conceptual Framework overrides any specific IFRS”. It is in these specific IFRS rules that the principle of accounting conservatism is still maintained at various points.

Examples include:

  • Measurement of inventories at the lower of cost and net realizable value (IAS 12 No. 9);
  • Net realizable value of inventories (IAS 12 No. 28 et seq.);
  • Revenue measurement at the fair value of the consideration received or receivable (IAS 18 No. 9 et seq.);
  • Deduction from revenue of amounts whose collectibility is uncertain (IAS 18 No. 22);
  • Recognition of revenues related to services only to the extend expenses involved are recoverable (IAS 18, No. 26):

Friday, January 13, 2012

Share Buy-backs in 2011 - Legal Framework, Reasons, Criticism, and Parameters

2011 has been a year of numerous share buy-backs.

Some major examples of last year’s buy-back transactions are shown below:



Legal Framework

The legal framework of such operations depends on the legal form of the company (public limited company, limited liability company, etc.), the publicly or privately held status of the company, and the purpose of the buy-back and its legality under local legislation.

For example, French listed corporations can operate share buy-backs under the following simplified conditions:



Reasons for share buy-backs in 2011

As reported by the FT, the companies’ rationales for share buy-backs in 2011 were

  • Lack of M&A opportunities
  • Cheap debt (bond yields and interest rates) to finance buy-backs
  • Low stock markets in 2011
  • Boost the company's stock price
  • Increase earnings per share

Criticism of share buy-backs

Five main critiques raised against share buy-backs.

First of all, it is held that shareholders are not treated equally as is the case for special dividends. Especially, most investors appreciate a steady and predictable dividend growth and, hence, will prefer companies conserve heir cash for longer-term value creation such as investments and acquisitions.

Second, companies tend to operate share buy-backs when they have excess cash rather than when their stock prices are low.

Third, when share buy-backs are carried out when the share is undervalued, cash might be distributed at the wrong time because in times of low share price, capital might especially be needed.

Fourth, bond- and other debt-holders are left out in case of a share buy-back.

Finally, share buy-backs signal a lack of desire to invest in the business.

Parameters for a share buy-backs

When planning for a share buy-back, management should take into account the following parameters:

  • Cash needs
  • Strategic uses of cash (= right balance between returning cash to shareholders and keeping the financial flexibility for the business)
  • Market and environment changes
  • Chosen capital structure
  • Targeted rating and potential rating downgrade due to reduced creditworthiness.

Example of a share buy-back - Bouygues






Bouygues cited the below grounds for its buy-back offering:

  • Massive fall of the share price
  • Selling shareholders are offered a 30 % premium whereas remaining shareholders will benefit from approximately 11 % increase on EPS.
  • The company’s financial structure will be preserved.
  • Self-financing capacity covers working capital requirement fluctuations.
  • Employment policy, strategy, and dividends’ policy remain unaffected.

S&P’s rating downgrade was justified by

  • Impairment of credit ratios
  • Heavy capital expenditures to come in 2012
  • Reduced predictability of financial policy.

Further Reading

Please read my FT clipping list “Share Buy-backs” at http://clippings.ft.com/lists/share-buy-backs for more details on the above.

The documentation related to Bouygues’ share buy-back can be found at

http://www.bouygues.com/en/finance-shareholders/analysts-and-investors/investors-presentations/investors-presentations/
and
www.amf-france.org.

Friday, January 6, 2012

Accounting Conservatism under GAAP and Future Profitability

Does a strict application of the rule of accounting conservatism influence over the future profitability of a firm?

Ahmed and Duellman (Accounting and Finance 2011, 609 et seq.) answer this question in the affirmative and state that:
  • more conservative accounting leads to higher future operating cash flows and higher future gross margins;
  • more conservative accounting leads to lower likelihood and magnitude of special item charges.

Reading about the consequences of practicing accounting conservatism, I was wondering how this principle is codified and what its status in the GAAP accounting regulation is today.

The FASB discusses the principle of accounting conservatism (= principle of prudence) in the Statement of Financial Accounting Concepts No. 2 (paragraph 91 et seq.) and in the Statement of Financial Accounting Concepts No. 8 (BC3.27 et seq.).

Conservatism is defined as “a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered”.

Even though the FASB discusses accounting conservatism within the framework of reliability, it is not part of the this concept. As a matter of fact, the hierarchy of accounting qualities, as established by the FASB, is as shown in the above table. In this schema, the blue lines represent conflicts that the FASB expressly recognizes. According to the FASB, such conflicts alter the practical application of the principle of accounting conservatism as follows:
  • Conservatism in financial reporting should no longer connote deliberate, consistent understatement of net assets and profits.
  • If two estimates of amounts to be received or paid in the future are about equally likely, conservatism dictates using the less optimistic estimate. However, if two amounts are not equally likely, conservatism does not necessarily dictate using the more pessimistic amount rather than the more likely one.
  • It is preferred disclosing the nature and extent of the uncertainty surrounding events and transactions rather than applying the principle of accounting conservatism right away. The user of financial information should be in the best possible position to form his own opinion.