How Accounting Influences Company Valuation

Andrey Ivanov

Accounting: the new face of corporate governance risk

Investors have traditionally viewed the Russian equity market in terms of three major risk categories: political, economic and corporate governance. Recent stabilization in domestic economics and decreasing political uncertainty should increasingly turn investors’ attention to corporate governance issues.

Russia has clearly transcended the first stage of the corporate governance problem, direct and obvious theft. Currently, Russian companies, like their emerging market peers, are at the stage when some large and controlling shareholders actively abuse minority shareholders in an attempt to accumulate resources provided by the business. Accounting issues arise at the third stage of corporate governance evolution, when the management and large shareholders conceal resources from minority shareholders by misrepresenting the company’s performance or deliberately misconstruing rules and regulations. A number of Russian companies appear to have already reached this plateau.

Why accounting differences matter

Financial statements are an important record of the business dealings of any company. It is very important to evaluate how the imperfections of domestic accounting rules can influence the market ratios of Russian companies.

We believe that RAS reveals no fundamental differences when compared with IAS, which might render the analysis of Russian companies meaningless. At the same time, while RAS financial statements approach IAS financial statements in terms of form, they nonetheless display a number of variations in substance. Such variances usually cause overvaluation of business assets and profitability in RAS records and they should be eliminated prior to the comparative analysis of Russian companies with their international peers.

Five key differences

The main differences between IAS and RAS results usually originate from five key factors:

• While RAS states principles similar to IAS, their implementation in practice has some flaws. In actual accounting practice, form prevails over substance, and companies do not always follow the accrual basis or the conservative approach to potential losses. These factors tend to combine in RAS to overstate the real profitability and value of the business.
• RAS does not account for changes in the purchasing power of the ruble, which makes comparison of figures for consecutive years impossible under conditions of high inflation.
• RAS consolidation requirements were introduced only recently and have a short period of application in practice, which allows large and highly integrated companies the possibility to manipulate their financial statements.
• RAS financial statements are still mainly geared to meeting the information needs of tax and regulatory authorities. This causes operating costs to be understated by charging expenses directly to equity, not recording tax penalties and incorrectly classifying ‘other’ expenses.
• RAS practice does not allow management to use its own judgment in incorporating the fair market value of assets and the economic substance of transactions into accounting records. This usually inflates the book value of assets compared with their fair market value, overstates assets’ useful life and involves using exorbitant rates for asset revaluation during periods of hyperinflation.

RAS weaknesses can be eliminated

Despite the differences in accounting standards, comparative valuation may be conducted even for domestic companies which do not compile IAS financial statements. Such valuation should be based on two key ratios, EV/EBITDA and P/CF, which require only minimal adjustments to compensate for the significant differences between RAS and IAS. The P/S (market capitalization/sales) ratio is almost immune to differences in accounting rules, but does not allow the user to compare the financial efficiency and profitability of different companies. The P/E (market capitalization/net earnings) ratio is too dependent on accounting rules and even accounting variations used by different companies.

EV / EBITDA is a ratio of the enterprise value of the company to its earnings before depreciation, interest and tax expenses. This ratio is most useful for the comparative valuation of a business based on its operating efficiency. EV is calculated as the sum of the market value of company’s equity and its net debt (adjusted for the current cash position) . Valuation based on EBITDA allows one to compare companies operating under different accounting, taxation and macro environment conditions (i. e. avoiding differences in depreciation, taxation, FX and inflationary effects) .

P / CF is ratio of the company’s market capitalization to its operating cashflows. It gives a good indication of how the market estimates future cashflows generated by the company.

Reporting currency in an unstable economy

In view of Russia’s hyperinfla-tionary economic environment, we believe that financial statements presented in rubles with a constant purchasing power (as required by IAS) give the most reliable picture of a business. This approach, unlike reporting in a foreign currency, allows users to take into consideration both regulation and devaluation risks.

1998 was an exceptional year. Financial statements prepared both per domestic and international principles are of limited use for analysis in a year characterized by significant fluctuations and imbalance among the key financial indicators. There was a significant gap between consumer inflation, producer inflation and FX devaluation. Given the hyperinflationary environment, all companies faced the problem that non-cash monetary effects seriously distorted the analysis of real cashflows in their financial statements.

Since 1999, macro indicators have been approaching an equilibrium, with only a 5-7% difference between inflation and ruble depreciation. From 2000, we expect the currency translation of revenues and expenses, based on RAS financial statements, weighted at the average FX rate, not to result in any material discrepancies; these indices can then be used for valuation.

Influence of RAS-IAS adjustments on valuation ratios

1. IAS adjustment influences the valuation ratio,
2. IAS adjustment does not influence the valuation ratio

Andrey Ivanov, ACCA, is an Analyst at Troika Dialog. He can be contacted by e-mail: Andrei_L_Ivanov@trodial.ru. The Troika Dialog website address is http://www.trodial.ru.