Special Contributor

Arsenal vs. FFP in 2019/20 - Are We Screwed?

That’ll do pig. That’ll do.

by Tom Jones

FFP SUMMARY

To comply with Financial Fair Play clubs must break even or better on a rolling three-year aggregate. For example, to qualify under FFP in the 2019/20 season the club submits total profit and loss (P&L) from 2016/17, 2017/18 and an estimate of 2018/19 (official accounts are not available when submission is due). For 2020/21, the accounts for 2016/17 will be replaced with estimates for 2019/20 and so on. Owners can offset losses as much as 35m per year with cash investment, and clubs can deduct expenses on youth development and infrastructure from the calculation.

Seems reasonable, right? But as we will see, there can be some unintended consequences of this three-year window that clubs may not have anticipated. In Arsenal’s case, a large cash reserve was built up long before FFP as Arsene Wenger and the board kept player trading expenses down. Arsene finally started to spend the cash, but as of May 2018, Arsenal still had about 195m in “free cash.” We have repeatedly heard from management that money generated by the club is free for investment into the squad, so why in January of 2019 when faced with a tight race for the lucrative Champions League and key injuries did the club state it could only loan players while sitting on 200m?

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One prevailing theory is that Stan has tightened the purse strings to cover cost overruns at his LA stadium project. While a nice narrative, there is another possible explanation—that the fiscally responsible Arsenal are up against an FFP wall. As I’ll explain, the player trading and contract management at Arsenal the last few seasons have put the club in an accounting bubble which has ballooned and effectively made spending the cash pile very challenging even if KSE has given the green light to use it. To see this, we will need to first understand how the club accounts for player trading.

PLAYER TRADING ACCOUNTING

As fans we like the simplistic approach of following the cash balance numbers and annual “net spend” figures that are spouted in the articles we read. In truth though, there is no such item in the official accounts. Player purchases, renegotiations and sales are distinct types of transactions and are accounted for differently in both amount and timing.

Player Purchases

While a club may pay actual cash for a player’s registration from another club, this cash paid does not immediately go toward expenses (see highlighted portion of Official Arsenal Accounts below). This is because the new player’s registration is considered an (intangible) asset, and for accounting purposes the cost of assets is realized over their “useful life.” While the “usefulness” of some of Arsenal’s players is debatable (ahem, Mustafi), the club will spread out or amortize the cost of a player’s registration over the duration of the player’s contract.

This is useful for typical businesses so that when acquiring a large asset, they can spread that cost out and not take a huge hit on the bottom line in a single financial period. But typical businesses don’t have to deal with FFP, and Arsenal do.

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As an example of how this is done, we can look at the purchase of Alexis Sanchez by Arsenal. He was bought for reported 35m in 2014 on a 5-year deal. That 35m did not go on Arsenal’s P&L for 2014 as an 35m expense, however. Instead, Arsenal booked his registration as an intangible asset with a cost of 35m. Each year for the term of the contract they amortized that value down by 7m (35m/5yr) and booked the 7m as an amortization expense (see the line item below). So, in terms of affecting the P&L, and therefore FFP calculations for that season, Sanchez only “cost” the club 7m in 2014 even though they might have paid the 35m up front in cash. Of course, this meant he was still hitting this line item for 7m in 2016 as well.

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Contract Renegotiations (extensions)

In these situations, club accounting policy (see below) is to take the remaining amortization of the player’s registration (what’s left to expense from the initial purchase or prior renegotiations), add that to the cost of the new contract (certain bonuses, Agent’s fees, etc.) and then amortize that “total cost” over the life of the new contract.

Consider the Ozil deal. At the time, Ozil had about 6 months left on his original cost of 42.5m. So, the club maybe had about 4m remaining to amortize. Certain bonuses to the player, agent’s fees for the new deal, etc. are added to that remainder (maybe 10m for such a huge deal). Therefore, we have maybe 15m as the total cost of Ozil’s current registration. The club will spread that over next 3 years (duration of his new deal) by taking an amortization expense of 5m every year. So Ozil hits the bottom line to the tune of negative 5m or more per year on top of his 18m per year salary. Easy to see why the club possibly wanted him off the books in January.

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Player Sales

When a player is sold, the remaining amortization is subtracted from the sale price and the result is what hits the bottom line as either profit or loss.

Consider the rumored sale of Xhaka this summer for 50m. While the club might receive a check for 50m, that money will not contribute to the P&L as a 50m income. At the time of sale, the club must charge off the remaining amortization left on the player’s registration. As we learned from the sections above on purchases and renegotiations, the club is yet to fully realize Xhaka’s initial purchase price and he also renegotiated his deal in 2018 further adding to his “cost”. When he is sold, this remaining amortization would need to be realized which would offset some of the 50m income from his sale.

In detail, Xhaka’s original deal was reported as 35m for 5 years so the club was charging 7m off each year. At the time of renegotiation in 2018, the club still had 21m (7m per remaining year) left to amortize. He renegotiated for reported 5 more years. So, add another few million in agent’s fees and bonuses and you probably have 25m left. Subtract the amortization taken in 18/19 (1/5th) and you are left with about 20m or so to amortize at the time of sale. Therefore, if Xhaka is sold for 50m this summer, the club may see an increase in cash by 50m but will actually only book an income on the P&L of 30m from the transaction.

Again, for a typical business this is good. It can essentially shield the bottom line from huge fluctuations when a large asset is sold (i.e. dodge the tax man). However, these costs are being spread out over 5 or more years while profits from sales are being realized in one season. With only a three-year window for FFP it’s easy to see that occasionally this may cause a problem if not considered by management.

A prime example of how this disparity can unexpectedly affect the P&L can be seen in Arsenal’s spending in 17/18. At first glance the net spend in cash terms was close to zero (3m net income according to tranfermarkt.com) with sales of Giroud, Ox, Walcot, etc. essentially balancing out purchases of Auba, Laca, etc. However, due to these accounting practices, Arsenal actually booked a 120m income on player “disposals” that year (see P&L from 2018 below) which was only offset by player trading expenses of 91.7m. Essentially Arsenal only generate 3m in cash from player trading that year but booked a net positive of about 30m toward the bottom line.

How is this possible? Due to the accounting differences between purchases and sales we explained above, most of the cash from the outgoing players was booked as profit for 2017/18 while most of the cost of incoming players is spread out to future years. This is the problem Arsenal are facing with respect to FFP.

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Another good example is the Sanchez/Miki swap deal with United. To the fan, it seems like a net-zero even swap since no cash was exchanged between the two clubs. However, for accounting purposes this was a sale of an asset (Sanchez) and a purchase of another asset (Miki). For this one, the club uses the fair market value of the players (reported as 35m in this case). So the club booked an income of 35m from the Sanchez “sale” for that year (less any remaining amortization). But for Miki, the club will spread the 35m “cost” over the 3.5 years of his contract (10m per year). The effect of this is that the club booked a “profit” on the exchange of perhaps 20m or more for the year 2017/18 even though no cash was exchanged.

Of course, there is no such thing as a free lunch, and the club still amortizing Miki’s registration at the clip of 10m per year and over time this will net out to zero. But, by taking the profit in one year and the expense in future years can really hurt the bottom line when the year of the profit drops out of the FFP calculation, but the years of the expense remain—essentially a 50m swing in this example. More on this in the FFP section below.

What is the consequence of all of this? From a business point of view Arsenal is actually doing okay in terms of revenue, cash and debt trends. But the way Arsenal have “timed” and structured their player trading in the twilight of Wenger’s reign means those deferred costs have created a bubble which is hitting the club’s P&L hard starting in 18/19 and likely continuing through 21/22.

FFP ANALYSIS

Now that we know how the accounts are handled, what does the FFP situation for Arsenal look like? Recall that according to FFP, Arsenal must profit or break even over a rolling three-year aggregate or face penalties. Let’s look at the next two seasons--2019/20 with the FFP window using accounts from 2016-19 and 2020/21 with the FFP window using 2017-20.

We have official accounts for 2016/17 and 17/18, but official numbers for 2018/19 haven’t been released and 19/20 hasn’t happened yet. In order to do some analysis, I have projected in the chart below based on what we do know about these seasons (no Champions League revenue, 18/19 signings, new Adidas and Emirates deals, etc.).

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As we can see, the club was in profit both of 16/17 and 17/18 despite the lack of Champions League revenue in 17/18. In 18/19 the club will still be amortizing the deals for Auba, Laca, ozil, etc. from 17/18, while the revenue from Theo, Giroud, etc. all was booked in 17/18. Further, the club essentially sold no one in 18/19 but bought new players (Leno, Torreira, etc.) spending about 75m. That expense will also be amortized in 18/19, 19/20 and beyond at about 15-20m/yr. Therefore, the club likely will see a jump in amortization expense that I estimate to be as much as 35m more than in 17/18. I keep staff and other wage costs the same.

Turnover due to property sales doesn’t count toward FFP, the commercial/TV deals were basically the same, and there was no Champions League revenue in 18/19 so FFP revenues will likely be the similar to 17/18. Therefore, in 18/19, Arsenal will likely see a huge jump in expenses due to the signings of 17-19 along with the stall in revenue due to no Champions League. This will culminate in a huge P&L loss for 18/19 which I estimate could be about 92 million.

That is a huge loss, but for the season 2019/20 FFP calculation Arsenal had the profits from the previous two years to offset this loss for an aggregate profit over the three years of about 15m. Not bad, but I think I’ve been conservative here by not accounting for any extra expenses relating to the departure of Wenger, Gazidiz, Sven et al. and the appointment of their replacements. I suspect this 15m may actually be closer to zero. In any case, this number doesn’t offer a lot of wiggle room, and so it is a possible explanation why the club announced it could only loan players in January.

But what about 2019/20 when the club has additional revenue from Adidas (30m/yr more than Puma) and Emirates (10m/yr more than before)? The club is also trimming its wage bill significantly with the departures at least of Cech, Ramsey, Leichsteiner, Wellbeck, Jenko, etc. so at least 20-30m in reduced annual wages and even further reduction in amortization costs. With these considerations, I project that Arsenal will reduce wage and amortization expenses by about 50M next year not including any signings or contract extensions. With the 40m more in extra revenue, 50m less in expenses, and healthy cash balance Arsenal should be good to make signings in the summer of 2019, right? Not necessarily.

Since there is no Champions League football for 19/20, even with the new kit deals and trimming the fat a little, I project Arsenal will likely still see a small net loss on the season of 19/20 of around 2m (assuming no player trading). A big improvement compared to the huge loss of 18/19. However, the problem with respect to FFP is that the very profitable year of 16/17 (+43m) now drops out of the FFP calculation for the 20/21 season. Arsenal will then have a loss in two of the three years considered by FFP for the 20/21 season. Put another way, without doing “something” positive in 19/20 Arsenal will be about 30m behind the FFP target of break-even over the three-year window from 2017-20 and could face FFP sanctions for the season of 2020/21.

IMPLICATIONS FOR SUMMER TRADING

We’ve all seen the rumored net of 40m to spend this summer. As one can see from above, club accounting with respect to player trading is not so simple. For example, Xhaka and Iwobi might be sold for the same cash amount, but Iwobi is an academy player and most of his fee would count to profit while Xhaka still has 20m left to amortize which will reduce his fee income. Basically, “net spend” is an oversimplification and useless with respect to club accounting if FFP is in play.

Disregarding this rumor and assuming my projections to be somewhat accurate, we know the club needs to offset FFP losses of 30m with player trading in 19/20 to avoid FFP sanctions for 20/21. However, this doesn’t mean the club has to make a net income of 30m on player trading (i.e. net spend -30m). Remember, player sales and purchases are accounted for separately and the club can take advantage of this to show a 30m “profit” on player trading even though in cash terms they actually have a positive net spend.

How? For an example, let’s say the club sell some combination of players for 50m income after all the remaining amortization of their contracts is realized (see Xhaka example above). This will hit the line item as profit from player disposals. We reserve 30m of this to offset the 30m FFP loss and 20m income is left. Does that mean the club only have 20m to spend? No. Remember, the expenses from purchases are spread out over the contract years of the new players. For example, assuming the club sign new players on 5 year contracts, they could spend a total of 100m this season and still comply with FFP next season since only 20m of the 100m (100m/5years) will hit as an expense in 19/20.

Of course, this effectively kicks the can down the road a bit more and if not balanced by revenues at some point could serve only to further inflate the bubble.

SUMMARY

In the latter seasons of Wenger’s reign, it seems he and Gazidis failed to adequately plan player trading and contract negotiations for future FFP compliance. Perhaps they were simply going all-in on a quick return of Champions League revenue, or maybe they just assumed the “well run” club of Arsenal didn’t need to be too concerned with FFP. For whatever reason, they made a huge FFP mistake in 17/18. While they didn’t “net-spend” that year, the effect of such high squad churn yielded a large profit in 17/18 and huge expenses realized in 18/19 and beyond. For a while, the profits and losses were balancing out, but the profitable years of 16-18 will be dropping out of the three-year FFP window leaving only the losses. These losses will have to compensated by profits in 2019/20. With no Champions League, the only meaningful way the club have to generate that kind of revenue is through more squad churn in 19/20.