Business News 10.8.2017 08:33 am

Eskom financials: an economic reality check

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When will government guarantees be reduced to dust?

International Financial Reporting Standards (IFRS) require that the financial statements of a company are prepared on a going concern basis, and that business and financial performance are “fairly presented”. The term “fairly presented” is subjective, hence IFRS contains rules to guide a decision.

But in reviewing a set of financials, at what point should one introduce an economic reality check? Is it possible that a company who is compliant with IFRS, can nevertheless be seen to be running into problems?

As an example, I discuss capitalised interest. IFRS mandates that the borrowing costs attributable to the acquisition, construction or production of “qualifying assets” should be added to the cost of those assets, and depreciated over the useful lifespan of those assets. A qualifying asset would be one that would take a long time to get ready for use. The technical term for including the interest in the cost of the assets is the “capitalisation of borrowing costs”.

Eskom appears to have an aggressive policy of capitalising finance costs to plant, machinery and equipment. In 2017 48.09% was capitalised (2016: 62.93%, 2015: 65.63%, 2014: R64.71%). The effect of these adjustments is shown in the table below.

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These finance costs would then be depreciated over the life of the qualifying assets. It is interesting to note that Eskom depreciates “generating” plant over six to 80 years, and “transmitting” plant over five to 40 years. Hence, an annual finance cost in regard to generating plant, instead of coming straight off income, can be spread over as long as 80 years. This results in a significant positive impact on profits. A certain amount of judgment will have to be applied in attributing the finance costs to the property, plant and equipment, and it is therefore not an accurate science. Although this is still in line with IFRS, does this policy artificially soften the economic burden of the finance costs paid?

It is to be noted that Eskom doesn’t provide the total amount of capitalised interest that is now part of the cost of property, plant and machinery. Nor does it give any information of the period of depreciation applied to capitalised interest. It would be interesting to know the percentage of property, plant and equipment that is attributable to finance costs. Which raises a further question, if the credit profile of an entity is such that it pays a much higher finance cost due to perceived higher risk, is it correct that this premium is also added to the cost of the plant?

In order to merely illustrate the impact of this policy, I have assumed that the finance costs are depreciated over 80 years, and expensed to the income statement as an eightieth. As this is simply an illustration, and the accumulated amount of capitalised finance costs is not available, only annual adjustments have been made. The effect on profits of including the total finance costs is shown in the table below.

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If you were a creditor or an investor, would you rely on the “fairly presented” profit of R888 million and comprehensive loss of R6.4 billion to make a decision? Or would you take into account the total finance costs for the year to arrive at an economic loss of R17.1 billion and comprehensive loss of R24.4 billion?

Not being in possession of the information in regard to the proportion of a company’s assets that are being financed with debt, it is not possible to calculate the asset ratio, which is used to determine the financial risk of a business. However, Eskom’s total debt securities and borrowings are R322.6 billion (note 25), representing 50.0% of total assets (2015: 48.6%).

The amount of capital introduced into Eskom by the government is growing. Additional share capital of R23 billion was issued to the government during the year, and a subordinated loan totalling R29.2 billion was converted to share capital. In effect, the government has now sunk a total of R83 billion into Eskom.

Eskom has approached Nersa for a further increase in its tariff, and has revalued its property, plant and equipment to justify this increase. However, a tariff increase, apart from being inflationary, will do little to cover the cost of borrowing, let alone put Eskom in a position where it can begin to pay off its debt.

The going concern status of Eskom is reliant on the assumption that the group has access to adequate resources. Presumably this takes into account the government guarantees of R134.8 billion, of which R33.8 billion was used during the year. It is perhaps time that the optimism placed on these apparent adequate resources is tempered by the current troubled economic conditions and the other financial demands being placed on government. A further downgrade will negatively impact government finances, and make it very difficult to raise further debt. This begs the ultimate question, how will Eskom survive?

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