We were remiss in not explaining why there is no apparent interest cost for the zero coupon convertible bonds mentioned in the Vignette. In normal times when interest rates are above zero, such coupon bonds are issued at a discount. Under both US GAAP and IFRS, when bonds are issued at a discount, the discount is amortized over the life of the bond at the effective interest rate. Hence an interest expense is recognized each year for zero coupon bonds when they are issued at a discount.

For bonds issued at a discount under both US GAAP and IFRS, the book value of the bond is transferred to equity at the conversion date But there is no additional recognition of the loss incurred from issuing shares at less than the market price. Further, since the book value of the bond when it is converted depends on the amount of interest amortized in previous years, the accounting credits equity with the interest expense recognized in previous years, effectively eliminating the cumulative interest cost from the book value of equity: Again, borrowing without affecting shareholders’ equity.

The Vignette refers to bonds issued in an unusual year, 2021, when interest rates were close to zero and at times even negative. Hence, the bonds were issued at (close to) par with no discount. Therefore, under both the US GAAP and IFRS accounting described above, no interest expense would be recorded for zero coupon bonds issued at par (the effective interest rate is zero).

Technically, IFRS is a little different from US GAAP in its general treatment of the convertible component of a convertible bond. IFRS requires the separation of an equity component representing the conversion option.  (In rare cases US GAAP also requires the recognition of an equity component. This happens when there is a so-called beneficial conversion feature – or BCF – when the conversion price is less than the equity market price at issuance.) However, the equity component is only defined as the residual obtained after subtracting the liability (straight bond) component from the issue proceeds. When interest rates are zero, e.g., in 2021, the liability equals the proceeds and there is no residual to be recognized in equity due to the conversion option. Therefore, there would still be an off-balance sheet liability with no interest cost.

AI is already significantly impacting value investing in my research. Deepseek can handle about 80% of my value investing process. It reads tons of latest research reports and investment thesis and is highly knowledgeable about companies’ histories and news. It even puts your (investment) books into training! I tested Tencent’s version of Deepseek on a company’s financials, and it accurately reformulated the balance sheet (95% accuracy), calculating NOPAT, RNOA, Value, and r. While it still struggles with multi-year reports, I’m confident AI will improve quickly.

That sounds reasonable, but there is an important subtlety. If a firm buys inventory that it can sell tomorrow with high probability, it books it as an asset on the balance sheet, If a firm builds a plant to produce inventory that it can sell with high probability, it books the plant to the balance sheet. But if a firm invests in R&D that has produced no product of revenue as yet…and it might not be successful…should the investment be booked to the balance sheet? There is a lower probability of payoff, so should an asset be booked with the pretense that it provides collateral? We are told that 85% of R&D investment is unsuccessful.

The investor is interested in the payoff to investment, and th ecutting edge here is the probability of payoff. That is the criterion for capitalizing assets in the balance sheet under FASB and IFRS accounting standards. For the accounting for R&D under FASB Statement No. 2, the FASB requires the investment to be expensed due to the “uncertainty of future benefits.”  In IAS 38, the IASB applies the criterion of “probable future economic benefits” to distinguish between “research” (which is expensed) and “development” (which is capitalized in the balance sheet and amortized). Even IAS 16 on property, plant, and equipment requires benefits to be “probable” for the asset to be booked.

Reporting R&D just says an expenditure has been made, nothing about the likely payoff. So the criterion for booking any asset to the balance sheet is the probability of future benefits. That suits the investor who is concerned about the risk to payoffs. Indeed, we will see in chapter 8 on risk to value that the expensing of intangible assets to the income statement conveys important risk information to the investor. The accounting authorities might not have the precise calibration as yet, but the investor is warned: Buying a firm with R&D with relatively low probability of payoff (an R&D startup, for example) is risky. And that applies to other intangible assets. For expenditures on advertising or brand building, it is uncertain whether the customers will be hooked. For investment in human capital, the outcome is uncertain; the employees may leave and go to a competitor. And so for investment to develop supply chains and distribution systems, customer loyalty programs, software development, merger costs, start-up and organization costs, and more.

For more on this, see

Barker, R., A. Lennard, S. Penman, and A. Teixeira. 2021.Accounting for Intangible Assets: Suggested Solutions.” Accounting and Business Research Vol. 52 No. 6, 601-630

Penman, S. 2023. Accounting for Intangible Assets: Thinking it Through. Australian Accounting Review Vol. 33 No. 1, 5-13.

Penman, S. 2024. Empirical Research on Capitalizing Intangible Assets is Logically Incoherent. At https://ssrn.com/abstract=4982366.

While profitability decreased after 2021, the stock price increased from $124.3 to $415.70 over the same period. How can the stock price rise while profitability declines?

As chapter 6 instructs, there are two main drivers of value added (residual income), RNOA and net operating assets (NOA):

ReOI_t = (RNOA_t – r_Firm) x NOA_t-1

RNOA is the return per dollar of NOA, but residual operating income (ReOI) is determined by the amount of NOA earning at that rate of return. Here are the NOA for Microsoft from 2019-2024 (in billions):

While RNOA was declining, NOA was increasing. The is partly due to the acquisition of Activision Blizzard in 2023 and the continuing investment in cloud computing and AI. With this growth in NOA, the residual operating income for 2019-2024 (in billions with a required return of 8%) is increasing:

RNOA and NOA are the two summary drivers of ReOI. These, in turn, are driven by their drivers. This is the fundamental analysis of chapter 7.

Again, here is the short-form valuation formula:

Adding a target’s NOA to the balance sheet reduces RNOA₁. And it reduces  because NOA₀ increases as well.

Here a typical path of RNOA for a mature pharmaceutical firm that had invested in R&D:

With R&D investment missing from NOA in the balance sheet, RNOA is high from 2020-2022. But at the end of 2022, the firm acquired another pharmaceutical firm That reduces the RNOA because NOA increases.

The mistake is to see the decline in RNOA as a loss of value. No: Carry the Balance Sheet with You. In the valuation formula, the increase in NOA₀ offsets the decline in RNOA and residual income. See the Procter and Gamble acquisition of Gillette in chapter 6 and chapter 11.

RNOA₁ can be high because assets are missing from its denominator, NOA₀. That results in a higher residual income. But correspondingly, the book value term in the valuation, NOA₀ is lower. Indeed, it exactly offsets the higher RNOA₁, leaving  unaffected. See the illustration with Coca Cola in chapter 6. Carry the Balance Sheet with You.

The same point applies to RNOA₁ generated by accounting manipulation. The mischievous accountant can increase next year’s operating income and RNOA₁ by writing off assets. But that reduces NOA₀. Carry the balance sheet with you to protect against such mischief.

• The denominator of RNOA excludes investments that are not booked as assets on the balance sheet. If the income from these omitted assets are in the numerator, RNOA is high even though the firm might not be particularly profitable. The Coca Cola Company is an example: It’s RNOA is typically about 30% making it looking very profitable. But that’s because its brand is not on the balance sheet. And so with a mature pharmaceutical company with income from its R&D but the R&D investment not in the denominator of RNOA.
• Investments not booked to the balance sheet, like R&D and brand investments, are expensed against income in the numerator, reducing the RNOA measure. That’s the case with an early-stage pharmaceutical firm with large R&D expenses but little income as yet. (Under IFRS, only R is expensed, not D).

These features are of courses due to how the accounting works. A measure of the rate of return on investment ideally compares the return to investment (in the numerator of the calculation) to the amount of investment (in the denominator), a measure that appropriately separates stocks from the flows they generate. That measure of “real” profitability is the one that economists have in mind and the interpretation often made in profitability analysis. However, accounting profitability mixes stocks and flows. Some investments are charged against earnings in the numerator, mixing investment with the return to investment, with the consequence that the investment is not in the denominator; accounting profitability is not economic profitability. This is increasingly so with much of investment now days in so-called intangible assets that are expensed against earnings: Research and development (R&D) expenditure, brand building, investment in supply chains and product distribution systems, customer loyalty programs, human capital, organization and start-up costs, and software, to name a few. Taking the measure at face value, low profitability is judged as poor investment performance, but that is not necessarily so if it is reduced by expensed investment that potentially generates profitability.

Are accountants mad? No, there is method in the madness. The accounting is a reaction to risk (in R&D investments, for example): Don’t book very risky investments to the balance sheet with the pretense that they provide collateral. This is called conservative accounting, an appropriate name in the face of risk: Be conservative, be prudent. Chapter 6 mentions this, but it is taken up in earnest in chapter 8 on risk. There you see how informative the accounting for RNOA is, telling you about the risk of investing. So, a low RNOA due to expensed R&D, as in the early-stage pharmaceutical start-up, indicates a risky investment: The R&D may not pay off. In terms of the accounting criterion for recognizing assets, the “probability of future benefits” is relatively low. Correspondingly, a high RNOA is relatively low risk: The (R&D) asset is not in the denominator but the (R&D) investment has paid off: Income realized; risk resolved. Coke, with a high RNOA, is low risk.

There are further reasons for the warning to beware of profitably measures:

• A manipulative accountant can create a high RNOA by writing down assets excessively. These assets become future expenses (like cost of goods sold, depreciation, and amortization) so writing down assets will reduce future expenses, yielding higher profits.
• A merger or acquisition will almost always yield lower RNOA for the combined companies.

Chapter 6 explains.

There are three issues with this calculation. First, Total Debt includes operating debt…operating liabilities generated in the course of business…which are not financing debt. Second, Total Debt is not reduced by debt assets (negative debt) to yield Net Debt. Third, Equity can include preferred equity which is effectively debt from the common shareholders’ perspective.

The same criticism applies to

The correct calculation for financing leverage is:

This is appropriate measure for equity analysis. The standard measure is appropriate for credit analysis where the issue is coverage of all debts.

ROOA, Return on Operating Assets, is the return without operating liabilities.

Operating Liability Leverage, is the amount of operating liabilities as a component of net operating assets.
Financing leverage levers ROE according to the financing leverage equation:

The two leverage effects can be combined into one equation:

The drivers of the two leverage effects are in the respective leverage equations.

A professional sports team gains revenue from stadium ticket sales, broadcasting rights, food and drink concession sales, and sales of sports attire. Expenses include player and staff salaries, concession supplies, and depreciation on stadium and training facilities. The team plays to booked out crowds but, with escalation in players’ salaries, the operation just breaks even.

In 2005, a consultant advises on strategy to enhance profits: Sell multiple-year season tickets to enthusiastic fans, payment upfront. Modify the stadium to incorporate luxury boxes sold to corporations on multiple-year contracts, cash up front. Sell concession rights to franchisees, cash up front. Require longer payment terms from suppliers of sports and other equipment. Modify player contracts with a deferred payment element in the form of a pension.

The consultant presents a pro forma balance sheet to the team owners who balk at the increase in liabilities with deferred revenues, accounts payable, and player retirement liabilities. But the consultant points to the increase in cash from the upfront payments and longer-term payables, cash that the owners can invest, not only in securities but also in the stadium modifications. Indeed, the consultant advises the construction of a new stadium with more capacity for season ticket revenue and up-market concession franchises. Sensibly, the owners also ask for a pro forma income statement. That forecasts higher revenue with fan participation and higher concession revenue. Expenses increase because of higher stadium depreciation, but bottom-line income increases.

The increase in cash comes without additional investment by the owners. They are using cash from customers and suppliers; operating liability leverage finances the business with added value. Perhaps the consultant should demonstrate the value added with increased RNOA and residual income.