Book 2: FRA Flashcards
1
Q
What is the COGS equation?
A
COGS = beginning inventory + purchases - ending inventory
2
Q
What is the specific identification method?
A
An inventory cost formula where specific costs are attributed to identified items of inventory (each unit sold matched with units actually cost). Required for items that are not ordinarily interchangeable, or are produced and segregated for specific projects. (IAS 2.23)
3
Q
What is the weighted average cost method?
A
An inventory cost formula where the cost of each item is determined from the weighted avg of the cost of similar items at the beginning of the period and the cost of similar items purchased or produced during the period (may be calculated on periodic [at end of period] or perpetual [as each additional shipment is received] basis). During inflation, will produce a value in-between LIFO and FIFO. (IAS 2.25)
Cost of goods AFS = Beginning inventory + purchases
Avg cost per unit = Cost of goods AFS / Quantity AFS
COGS = Avg cost per unit * Quantity sold
Ending inventory = Avg cost per unit * Quantity remaining
4
Q
Under what cost formulas are ending inventory and COGS the same regardless of periodic or perpetual calculation?
A
FIFO and specific identification.
5
Q
What is the LIFO reserve?
A
Difference between FIFO inventory and LIFO inventory.
LIFO reserve = FIFO inventory - LIFO inventory
FIFO inventory = LIFO inventory + LIFO reserve
6
Q
How to convert from LIFO to FIFO?
A
1) FIFO inventory = LIFO inventory + LIFO reserve
If it’s avg inventory, just avg both the inventory and the reserve and add them together.
2) FIFO cash = LIFO cash - (LIFO reserve * tax rate)
This subtracts taxes on the LIFO reserve because LIFO firm pays lower taxes and therefore more CFO.
3) FIFO equity = LIFO equity + (LIFO reserve * (1 - tax rate))
This is because LIFO firm has higher COGS and therefore lower net income to go to RE.
4) FIFO COGS = LIFO COGS - (end LIFO reserve - beg LIFO reserve)
COGS is lower under FIFO.
5) FIFO net income = LIFO net income + [(end LIFO reserve - beg LIFO reserve) * (1 - tax rate)]
NI is higher under FIFO (because COGS is lower in an inflationary environment).
FIFO net income can also be arrived at by adjusting FIFO taxes (adding the tax on change in the reserve). ie:
FIFO taxes = LIFO taxes + [(end LIFO reserve - beg LIFO reserve) * tax rate)]
6) FIFO RE = LIFO RE + [LIFO reserve * (1 - tax rate)]
7
Q
How to compute FIFO COGS or FIFO net income from a LIFO basis?
A
Change in LIFO reserve = ending LIFO reserve - beginning LIFO reserve
FIFO COGS = LIFO COGS - Charges included in COGS for inventory write-down - Change in LIFO reserve
COGS is lower under FIFO.
FIFO net income = LIFO net income + [(Change in LIFO reserve ) * (1 - tax rate)]
NI is higher under FIFO (because COGS is lower).
FIFO net income can also be arrived at by adjusting FIFO taxes (adding the tax on change in the reserve). ie:
FIFO taxes = LIFO taxes + [(end LIFO reserve - beg LIFO reserve) * tax rate)]
8
Q
What’s LIFO liquidation?
A
When a firm’s LIFO inventory is declining, and therefore older, lower costs are now in COGS. This results in higher profit margins (lower COGS) and higher tax. These higher profit margins are artificial and unsustainable.
To adjust for this, should add the decline in the LIFO reserve (the difference between inventory at FIFO and LIFO) caused by a decline in inventory back to COGS. (note this is the opposite to computing FIFO COGS from LIFO, where the change in LIFO reserve is deducted from LIFO inventory).
9
Q
What is the inventory valuation method under IFRS? US GAAP?
A
IFRS: lower of cost or net realisable value
Net realisable value is estimated selling price in ordinary course of business less the estimated costs of completion and estimated costs necessary to make the sale. (IAS 2.6)
Inventory can be written down if NRV is less than cost. NRV can also be written back up if there is a recovery in value, but the gain is limited to the amount previously recognised as a loss and can’t be written up above original cost. (IAS 2.33)
US GAAP: lower of cost or market
Market is usually replacement cost. Market cannot be greater than NRV, or less than NRV - normal profit margin. In effect, market is straddled by NRV and NRV - normal profit margin.
No write-up is allowed in US GAAP for subsequent recoveries in value.
10
Q
What changes in inventory levels should an analyst be on the look out for?
A
An increase in raw materials or WIP may indicate an expected increase in demand.
Increased finished goods inventory while raw materials and WIP are decreasing may indicate decreasing demand.
11
Q
Inventory turnover ratio
A
COGS / avg inventory
12
Q
Gross profit margin
A
Gross profit / revenue
13
Q
Net profit margin
A
Net income / revenue
14
Q
Return on assets
A
Net income / avg assets
15
Q
Days inventory on hand
A
365 / inventory turnover
inventory turnover = COGS / avg inventory
16
Q
What’s the effect on net income and equity of capitalisation?
A
Delays recognition of expense to subsequent periods (via depreciation). Conversely, if a firm expenses in the current period, net income is reduced by the after-tax amount of the expenditure.
ie Capitalisation results in higher net income in first year and lower net income in subsequent years than expensing.
Over the life, total net income is identical.
Because it results in higher net income in the period, it also results in higher equity (retained earnings). This reduction is deferred to later periods (via depreciation).
17
Q
What’s the effect on CFO of capitalisation?
A
A capitalised expenditure is usually an outflow from investing activities.
Conversely, if expensed, it’s reported as an outflow from operating activities.
So, capitalising results in higher CFO and lower CFI than expensing. Total CF is the same.
18
Q
What’s the effect on ROA and ROE of capitalisation?
A
Capitalisation initially results in higher ROA and ROE because of higher net income in first year. Subsequently, ROA and ROE will be lower as net income is reduced by depreciation.
Expensing causes ROA and ROE to be lower in first year and higher in subsequent years. Though net income is lower in first year, it is higher in subsequent years (and assets/equity is lower) than if it was capitalised.
19
Q
What interest rate is used to capitalise interest?
A
It is based on the debt specifically related to the construction of the asset. (IAS 23: actual borrowing costs incurred to extent entity borrows funds specifically).
If no construction-specific debt is oustanding, it is based on existing unrelated borrowings. Interest costs on general debt in excess of construction costs are expensed. (IAS 23: apply capitalisation rate to expenditures to extent entity borrows funds generally).
20
Q
How is capitalised interest classified in CF statement?
A
Generally as outflow from CFI. Comparatively, regular interest expense is outflow from CFO.
21
Q
What’s the interest coverage ratio and how does capitalisation affect it?
A
interest coverage ratio = EBIT / interest expense
Capitalisation initially results in higher ICR, because of lower interest expense.
In subsequent periods higher depreciation results in lower EBIT, so there is lower ICR.
ICR based on total interest expense (including capitalised interest) is considered a better measure of solvency by many.
22
Q
How to adjust financial statement to reverse effect of capitalising interest?
A
1) Interest expense + capitalised interest in year
2) Total assets - capitalised interest + depreciation due to capitalised interest to date (which wouldn’t have happened)
3) Depreciation expense + depreciation due to capitalised interest
4) Subtract interest capitalised from CFO and add to CFI (capitalised interest is usually reported as an outflow from CFI)
23
Q
How are internal development costs accounted for?
A
With some exceptions, they are expensed as incurred.
R&D:
IFRS: research costs are expensed as incurred, but development costs are capitalised.
GAAP: both research and development costs are expensed, with the exception of software development costs.
Software development costs (GAAP): expense until technological feasibility has been established, after which should capitalise. Also capitalise costs for software development for internal use.
Rememba: Capitalisation results in higher net income in first year and lower net income in subsequent years than expensing.
24
Q
What’s the equation for straight-line depreciation?
A
depreciation expense = (original cost - salvage value) / depreciable life
25
What's the equation for DDB depreciation?
DDB depreciation in year x = (2 / asset life in years) * book value at beginning of year x
26
Whats the equation for units-of-production method depreciation?
depreciable basis / number of units expected over life of asset
depreciable basis = original cost - salvage value
27
How is a change in depreciation method treated in IAS 8?
As a change in accounting estimate, and therefore put into effect in the current period and prospectively.
Entities can manage earnings through the choice of estimated lives and salvage values.
28
When must entities test non-financial assets for impairment?
IFRS: must annually assess whether there is indication impairment has occurred. If there is, then should test for impairment.
US GAAP: test for impairment only when events and circumstances indicate firm may not be able to recover the carrying value through future use.
29
How is a non-financial asset assessed for impairment?
IFRS: asset is impaired when carrying value exceeds the recoverable amount.
Recoverable amount is greater of "FV less selling costs" and "value in use". Value in use is the PV of future CFs from continued use.
If impaired, asset is written down to recoverable amount and impairment loss is recognised.
In IFRS, loss may reverse.
US GAAP: two steps: determining recoverability and measuring the loss
Recoverability: asset impaired if carrying value is greater than undiscounted future CFs.
Loss measurement: if impaired, write down to FV (or discounted value of future CFs if FV is not known) and recognise impairment loss.
In US GAAP, loss may not reverse.
30
How is the impact of a revaluation in IAS 16 recognised in the income statement?
If initial revaluation caused carrying amount to INCREASE, recognise that increase in OCI and accumulated in equity as revaluation surplus (ie increases equity). Subsequent losses would reduce OCI to the extent of the gains.
If initial revaluation caused carrying amount to DECREASE, recognise that decrease in P&L. Subsequent gains would be recognised in P&L until they exceed the initial loss, at which point they are recognised in OCI and accumulated as revaluation surplus.
```
OCI
{}
COST
{}
P&L
```
31
What's the equation for average age? Avg depreciable life? Remaining useful life?
Avg age = accumulated depreciation / annual depreciation expense
Avg depreciable life = end gross assets / annual depreciation expense
Remaining useful life = end net assets (net of accumulated depreciation) / annual depreciable expense
Compare annual capital expenditures to depreciation expense for indication of whether firm is replacing PP&E at same rate as assets are depreciating.
32
What is a finance lease? Operating lease?
```
Finance lease (capital lease in US GAAP):
IFRS: transfers substantially all risks and rewards incidental to ownership
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US GAAP: either
- title transferred to lessee at end
- bargain purchase option exists
- lease period is 75%+ of asset's life
- PV of lease payments is 90%+ of FV of asset
In substance, a purchase of an asset that is financed with debt). Lessee adds equal amounts (lower of FV or the PV of lease payments) as asset and liability on its balance sheet, and over time recognises depreciation expense on asset and interest expense on liability.
Operating lease: any lease other than a finance lease (in substance, a rental arrangement). No asset or liability reported by the lessee, and periodic lease payments recognised as rental expense.
33
What are the benefits of leasing compared to traditional financing?
Less costly financing (no initial down payment)
Reduced risk of obsolescense (can return to lessor)
Less restrictive provisions (more flexibility in negotiations)
Off-balance-sheet financing (operating leases)
Tax reporting advantages (in US, synthetic lease whereby lease is treated as owned asset for tax purposes, and rental agreement for financial reporting)
34
What is the reporting by the lessee for a lease?
Operating lease: no entry at inception. Recognise rent expense equal to lease payment during term. Lease payment is outflow from CFO.
Finance lease: at inception the lower of the PV of future lease payments or FV is recognised as equal asset and liability by lessee. Over term, recognise depreciation expense on asset and interest expense on liability.
Total expense under finance lease = interest expense + depreciation.
Interest expense = lease liability at beginning of period * interest rate implicit in lease
The finance lease payment is separated into interest expense (CFO, or in IFRS CFO or CFF) and principal (CFF)
35
What are the financial statement effects of leasing?
Balance sheet: finance lease results in reported asset and liability, operating lease doesn't.
Income statement:
Lessee: EBIT (operating income) is higher for finance lease than operating lease. With operating lease, the entire lease payment is an operating expense, whereas for finance lease only the depreciation expense (not the interest expense) is. Operating lease will show higher profits for lessee in early years, because lease expense is less than sum of interest and depreciation expense.
Lessor: EBIT is higher for direct financing lease than operating lease, because due to amortisation interest is higher in early years. This reverses in later years.
CF: total CF is unaffected.
Lessee: CFO is higher for operating lease and CFF is lower, because finance lease puts portion considered interest expense through CFO and principal portion (lease payment - interest expense) through CFF. For lessee, CFO is higher for operating, because full lease payment is treated as operating CF. For finance lease, only portion of lease payment relating to interest expense potentially reduces operating CFs.
Lessor: CFO is higher for operating lease than a direct financing lease. With a direct financing lease, the lease payment is separated into interest (inflow to CFO) and principal (lease payment - interest revenue) (inflow to CFI).
36
How to derive interest rate for lessee?
A lessee should recognise depreciation expense on asset and interest expense on liability (lower of FV or PV of lease payments).
Interest expense = lease liability at beginning of period * interest rate implicit in lease
Interest rate = IRR of future lease payments
CF0 = -PV of future lease payments
CF1 = CF in year 1
...
Then, can use NPV function to compute PV of operating lease payments discounted at the IRR.
CF0 = 0
CF1 = rent expense year 1
...
37
What is the reporting by the lessor for a lease?
Operating lease: recognise the lease payment as rental income, and keep the leased asset on the balance sheet (and recognise depreciation).
Finance lease: lessor should recognise as finance (capital) lease if finance lease criteria is met and (for US GAAP) the collectability of lease payments is reasonably certain and lessor has substantially completed performance
US GAAP distinguishes capital lease between:
Sales-type lease: If the PV of lease payments > carrying amount of asset. Treated as lessor sold asset and provided financing to buyer. Recognise sale equal to PV of lease payments, and COGS equal to carrying value of asset. Different is gross profit. Asset removed from BS and a lease receivable equal to PV of lease payments is created.
In substance, it's as if lessor sold the asset for its fair market value and loaned the lessee the purchase price.
Direct financing lease: If the PV of lease payments = carrying value of asset. No gross profit is recognised at inception, rather lessor is providing financing to lessee. Asset removed from BS and a lease receivable equal to PV of lease payments is created.
On both finance leases the principal portion of payment reduces lease receivable, interest revenue is recognised equal to lease receivable at beginning of period * interest rate, and interest revenue portion is CFO inflow and principal portion (lease payment - interest income) is CFI inflow.
38
What are the tainting provisions for HTM assets?
When an entity's actions cast doubt on its intention/ability to hold HTM assets to maturity, the use of amortised cost for HTM assets is precluded for a reasonable period of time. (IAS 39.AG20).
Consequently, no FA should be classified as HTM if, during current year or preceding 2 years, the entity has sold or reclassified more than an insignificant (in relation to the total) amount of HTM assets before maturity, other than those done:
- close enough to maturity or call date so that changes in market rate of interest did not have significant effect on FV;
- after substantially all original principal had been collected;
- due to an isolated non-recurring event beyond the holder's control.
39
What are available-for-sale assets?
An FA is classified as AFS if it is designated as such or if it does not properly belong in one of the three other categories of FAs. In many respects it is therefore a 'default' classification. (IAS 39.9)
Assets that would otherwise be 'loans and receivables' may be designated as AFS at initial recognition.
AFS are measured at FV on each reporting date. Unrealised gains/losses is the difference between FV and carrying amount at that date. OCI is adjusted to reflect the cumulative unrealised gain or loss. The amount reported in OCI is net of taxes.
When AFS assets are derecognised, the cumulative amount in OCI is RECYCLED and reported as a reclassification adjustment on the statement of profit and loss.
Only forex gains and losses on AFS securities are recognised in P&L in IFRS. Under US GAAP, the total change in the fair value of AFS securities is in OCI.
40
Whats the difference between IFRS and US GAAP AFS measurement?
IFRS: Only forex gains and losses on AFS securities are recognised in P&L, any other unrealised gains and losses go through OCI
US GAAP: All unrealised gains and losses go through OCI
41
When can FIs be reclassified into or out of FVPL?
Generally FIs may NOT be reclassified into or out of FVPL. This is to impose discipline on entities. (IAS 39.50, BC73).
Eg, if an entity starts to trade an AFS portfolio, newly acquired investments will be FVPL, but the legacy portfolio will remain AFS.
There are certain exceptions if the FA is no longer being held for sale or repurchase in the near term:
- Can reclassify to loans and receivables if it meets definition and entity has intention and ability to hold it for foreseeable future or until maturity. (IAS 39.50D)
- Can reclassify to HTM or AFS in "rare circumstances", which are not described. (IAS 39.50B).
It is prohibited for derivatives or FIs designated at FVPL on initial recognition to be reclassified.
42
When can FAs be reclassified between AFS and 'loans and receivables'?
AFS to L&R: If FA would have met the definition of L&R and the entity has intention and ability to hold for foreseeable future or until maturity (IAS 39.50E).
L&R to AFS: IAS 39 neither requires nor prohibits this reclassification. EY thinks it is okay to do if applied consistently.
43
When can FAs be reclassified between HTM and AFS?
HTM to/from AFS are permitted. It depends on intention or ability to hold. (IAS 39.51)
If HTM tainting provisions are triggered, those remaining HTM assets should be reclassified to AFS.
When classifying from HTM to AFS, difference between AC and FV should be recognised as a gain/loss.
If it is no longer appropriate to classify an investment as HTM, it shall be reclassified as AFS and remeasured at FV, with difference between carrying amount and FV recognised in OCI.
44
How does US GAAP treat reclassification of FAs?
Allows reclassification of securities between all categories when justified.
45
How is an impairment loss measured (IAS 39)?
At the end of each reporting period should assess whether there is objective evidence of impairment.
The difference between the asset's carrying amount and the PV of estimated future cash flows discounted at the original EIR.
We use the original EIR because discounting at the current market rate would in effect impose fair value measurement on an amortised cost asset.
The carrying amount of an impaired asset is reduced either directly or through the use of an allowance account.
If, subsequently, the amount of the impairment loss decreases and that can be related objectively to an event occurring after the impairment was recognised, the recognised loss can be reversed either directly or by adjusting an allowance account. The reverse shall not result in a carrying amount that exceeds what amortised cost would have been. The reversal is recognised in P&L.
46
How is impairment recognised for AFS assets (IAS 39)?
When a decline in the fair value of an AFS asset has been recognised in OCI and there is objective evidence of impairment, the cumulative loss within OCI should be reclassified to P&L as a reclassification adjustment.
The amount of the loss is the difference between the acquisition cost (net of repayment/amortisation) and the current fair value.
In a subsequent period, if the FV increases and can be objectively related to an event, the impairment loss should be reversed and recognised in P&L.
47
How is impairment done under US GAAP?
HTM/AFS: Determine at reporting date whether decline in FVis other than temporary. If so, write down to FV. Realise loss in P&L.
For AFS: subsequent increases in FV are treated as unrealised gains or losses and included in OCI.
48
What is significant influence?
Significant influence triggers the equity method, and is the power to participate in the policy decisions of the investee, but not control or joint control those policies. (IAS 28)
Occurs when have 20%+ of voting power (including consideration of warrants, call options, convertibles, etc), and is evidenced by:
- representation on board
- participation in policy making process
- material transactions between each other
- interchange of management personnel
- provision of essential technical info
Equity method is supposed to provide a better representation of investment income for investments such as this.
49
What are joint ventures?
Defined under IFRS 11 Joint Arrangements as where parties that have joint control of arrangement have rights to net assets of the arrangement. (versus joint operation, where parties have rights to assets, and obligations for liabilities, relating to arrangement).
A joint venturer shall recognise its interest in a joint venture as an investment accounted for under IAS 28. (also must use equity method for joint ventures under US GAAP).
A joint operator accounts for its stuff in accordance with applicable IFRSs.
50
What is the equity method?
Recognise investment initially at cost, and increase/decrease carrying amount over time to recognise investor's share of P&L of investee.
Dividends/distributions from the investee to the investor are treated as a return on capital and reduce the carrying amount of the investment.
Equity method investments are non-current assets.
Equity method is used b/c supposedly recognition of income on basis of distributions may not be adequate measure of income earned by an investor on such investments. The investor can potentially influence distributions.
51
How to account for difference between cost of investment and share of net FV of identifiable assets/liabilities of investee under equity method?
Any difference between cost of investment and share of net FV of identifiable assets/liabilities of investee is:
- goodwill relating to investment is included in carrying amount of investment. It is not amortised.
- excess of share of net FV of identifiable assets/liabilities of investee is included as income in determination of entity's share of investee's P&L in period of acquisition. (IAS 28.32)
The excess amount of purchase price not attributable to identifiable assets/liabilities (ownership% * excess of FV over cost of asset/liability) is attributable to goodwill.
The excess purchase price allocated is accounted for consistently with the underlying asset (eg expensed or depreciated).
However, the adjustment effects are not reflected in financial statements of investee. The investor must directly record them by reducing the carrying amount of the investment on its balance sheet and by reducing its share of investee's P&L.
Purchase price
-Acquired equity in book value of net assets (% owned)
---
=Excess purchase price
-Attributable to an identifiable asset (% owned)
---
=Goodwill
52
How to subsequently account for/amortise difference between cost of investment and share of net FV of identifiable assets/liabilities of investee under equity method?
Purchase price
-Acquired equity in book value of net assets (% owned)
---
=Excess purchase price
-Attributable to an identifiable asset (% owned)
---
=Goodwill
Excess purchased price is accounted for consistently with the accounting treatment of the underlying asset/liability. So PP&E would be amortised, and an asset at FV would remain at FV.
```
Purchase price of associate
+Share of net income of associate
-(Dividends received)
-(Amortisation of excess purchase price attributable to PP&E)
---
=Dec 31 balance in investment
```
53
How is any remaining difference between acquisition cost and FV of net identifiable assets that cannot be allocated to specific assets treated? (equity method)
Any remaining difference between acquisition cost and FV of net identifiable assets that cannot be allocated to specific assets is treated as goodwill and is not amortised. Instead, it is reviewed for impairment on a regular basis. (IAS 28.32)
54
How is impairment of an equity accounted investment calculated?
IFRS: FIrst determine of OEOI from IAS 39, then go to IAS 36.
Compare carrying amount to recoverable amount. If carrying amount is higher, reduce to recoverable amount and recognise loss.
Recoverable amount is higher of 'value in use' or net selling price. Value in use is PV of estimated future CFs from continuing use and disposal. Net selling price is FV less costs to sell.
`
US GAAP: if FV declines below carrying amount, and that is considered to be permanent.
55
How to account for upstream/downstream transactions with equity accounted investment?
Downstream: from investor to investee
Upstream: from investee to investor
Investor's share of investee's gains/losses in these transactions is eliminted. (IAS 28.28)
Downstream: investor has recognised all the profit in its income statement. investor owns 30% and sells 40k goods to investee for 50k. Sold 90% by year end. Investor's profit is 10k, but must reduce by 300 (10k * 10% * 30%). Can recognise the profit once investee sells remaining inventory.
Upstrean: investee sells 15k in goods to investor who owns 30%. At end of year half of goods remain. Investor must therefore reduce its equity income $2250 (15k * 50% * 30%). After its sold, the 2250 will be recognised in equity income.
56
What are the analyst issues surrounding the equity method?
Questions about whether equity method is appropriate. If dividend payout ratio is less 100%, equity method usually results in higher earning compared to for other minority passive investments. Entity may use equity method to get higher income, while being actually unable to exert significant influence.
Also, nature of 'one-line consolidation' can avoid showing significant assets/liabilities.
Finally, consider quality of equity method earnings. Equity methods assumes that a % of each dollar earned by investee is earned by investor, even if cash is not received. So, consider potential restrictions on dividend cash flows.
57
What's the difference between a merger and an acquisition?
Merger: acquiring firm absorbs 100% of the target, and the target ceases to exist.
Acquisition: both acquirer and target continue to exist as legal entities, but are connected through a parent-subsidiary relationship. Acquirer provides consolidated financial statements. Unlike merger or consolidation, do not need to acquire 100% of target. If acquire less than 100%, must report minority interest.
Consolidation: A new legal entity is formed and the two previous entities cease to exist. As in a merger, in this case 100% of the target is purchased.
It is only under an acquisition that consolidated financial statements are produced (by the parent). In this case the parent and subsidiary also usually produce their own separate financial statements as well.
58
What was the pooling of interests method?
A method prior to June 2001 in US GAAP, and prior to March 2004 in IFRS (known as uniting of interests method in IFRS). Combined two firms using historical book values, and operating results were restated as though firms were always combined. Ownership interests continued, and former accounting bases were maintained.
59
How are direct costs associated with a business combination treated?
Expensed as incurred. Eg legal fees, consultants, etc.
60
How are identifiable assets/liabilities of target accounted for in business combination?
The acquirer measures indentifiable assets and liabilities at their acquisition-date fair values. (IFRS 3.18).
The purchase price is allocated to the identifiable assets/liabilities. Any remainder is reported on balance sheet as goodwill.
61
How does an entity account for contingent liabilities in a business combination?
Contingent liabilities should be recognised at acquisition date if it is a present obligation that arises from past events and its fair value can be measured reliably. (IFRS 3.22)
62
How does an entity account for indemnification assets in a business combination?
Indemnification assets are when the target contractually indemnifies acquirer for outcome of a contingency. Should recognise an indemnification asset at the same time it recognises an indemnification liability (the indemnified item) and measure them on the same basis. (IFRS 3.27)
63
What's the difference between full and partial goodwill?
In a business combination the purchase price is allocated to the identifiable assets/liabilities. Any remainder is reported on balance sheet as goodwill.
Partial (IFRS): measured as amount FV of acquisition (purchase price) exceeds ACQUIRER's SHARE of FV of identifiable assets/liabilities.
Full (US GAAP, IFRS): measured as amount FV of entity as a whole (purchase price / decimal amount purchased) exceeds acquirer's share of whole FV of identifiable assets/liabilities.
Shareholder's equity is higher under full goodwill.
64
How is goodwill of target treated in a business combination?
It is not amortised. It is tested annually for impairment. Once written-down, it can't be reversed.
Impairment occurs:
IFRS: if carrying amount of cash generating unit (where goodwill is assigned) exceeds recoverable amount, recognise impairment loss.
US GAAP: if carrying amount of reporting unit (where goodwill is assigned) exceeds FV, then an impairment exists. Measure loss as difference between carrying value of goodwill and implied FV of goodwill.
Implied FV is calculated in same way as goodwill at acquisition date (FV of reporting unit allocated to identifiable assets/liabilities as if acquired on impairment measurement date; any excess considered implied FV).
65
What is a bargain purchase?
Business combination in which FV of identifiable assets/liabilities exceeds price paid.
Acquirer hould recognise this amount in P&L as gain/loss on acquisition date.
66
What is non-controlling interest?
The amount of a subsidiary's equity the parent doesn't own (results from an acquisition). Presented in consolidated balance sheet as separate component of stockholder's equity. In income statement, NCI are presented as line item reflecting allocation of P&L for period.
Full goodwill method (US GAAP, IFRS): measure NCI at fair value, ie NCI% * FV of subsidiary.
Partial goodwill method (IFRS): measure NCI at proportionate share of acquiree's identifiable net assets, ie NCI% * identifiable net assets of subsidiary.
67
How did the FASB/IASB address the consolidation issue?
FASB developed guidance for 'variable interest entities'. An SPE is a VIE and must be consolidated by primary beneficiary if:
1) total equity at risk is insufficient to finance activities without financial support from other parties, or
2) equity investors lack any one of the following:
- ability to make decisions
- obligations to absorb losses
- right to receive returns
IASB: IFRS 10 Consolidated Financial Statements superseded SIC-12 Consolidation—SPEs.
68
How do IFRS/US GAAP differ in contingent assets/liabilities/R&D/restructuring costs of business combinations?
IFRS: Contingent liabilities should be recognised at acquisition date if it is a present obligation that arises from past events and its fair value can be measured reliably. Subsequently, measure at higher of amount initially recognised or best estimate of amount required to settle. Contingent assets are not recognised under IFRS.
US GAAP: recognise continent assets/liabilities at FV. Non-contractual contingent assets/liabilities are only recognised if more likely than not they meet definition of asset/liabilitiy.
In-process R&D acquired in a business combination is a separate intangible asset measured at FV (if it can be measured reliably). Subsequent periods, this R&D is subject to amortisation of a marketable product results or to impairment if no product results.
Restructuring costs are expensed as incurred.
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What is the pension obligation?
IFRS: PV of the defined benefit plan (PVDBO)
US GAAP: projected benefit obligation (PBO)
The actuarial PV of future benefits earned by employees for service provided up to date.
Current service cost: the PV of benefits earned by employees during current period. recognise as expense in P&L in IFRS.
Net interest expense/income: increase in obligation due to passage of time. Recognise in P&L in IFRS.
Past service costs: retroactive benefits awarded to employees at initiation/amendment of plan. Under IFRS, expense immediately along with current service costs. In US GAAP, recognised in OCI and amortised.
Remeasurements (IFRS): actuarial gains/losses, and any differences between actual return on plan and amount included in net interest calculation. IFRS remeasurements are all recognised in OCI.
```
PBO (beginning of year)
+ service cost
+ interest cost
+ past service cost
+/- actuarial gains/(losses)
- (benefits paid)
---
= PBO (end of year)
```
funded status = FV of plan assets - PBO. If PBO > plan assets, it's overfunded and that overfunding is reported as asset (subject to PV of future economic benefits resulting from overfunding, eg refunds or reductions in contributions). Must report funded status on BS.
Compute PV of annuity beginning at retirement, then compute PV of that down to current year to get current PBO for one employee.
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How is a defined contribution plan accounted for?
Expense employer's obligation for contribution into plan. No significant pension-related liability arises on BS, rather an accrual (current liability) is recognised at end of reporting period for any unpaid contributions.
Entity recognises contributions to a DC plan when an employee has rendered service in exchange for those contributions.
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How is a DB pension reported on balance sheet?
Funded status (FV of plan assets - PBO) must be presented on BS.
If PBO > plan assets, it's overfunded and that overfunding is reported as asset (subject to PV of future economic benefits resulting from overfunding, eg refunds or reductions in contributions).
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Explain the components of DB pension costs?
IFRS: periodic pension costs recognised in P&L include service costs (both current and past) and net interest expense/income. Costs recognised in OCI include remeasurements (net return on plan assets and actuarial gains/losses).
US GAAP: costs in P&L include current service costs, interest expense on plan liabilities, expected returns on plan assets (reduces cost), amortisation of past service costs, and actuarial gains and losses to extent not reported in OCI (via 10% of DBO or FV of plan assets corridor effect)
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Component of DB costs: Service costs—difference between IASB/FASB?
IFRS: recognised in P&L
GAAP: current service costs recognised in P&L, past service costs recognised in OCI and subsequently amortised to P&L over serivce life
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Component of DB costs: Net interest income/expense—difference between IASB/FASB?
IFRS: recognised in P&L as: net pension liability or asset * interest rate
GAAP: Interest expense on pension obligation recognised in P&L. Expected return on plan assets recognised in P&L as: plan assets * expected return.
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Component of DB costs: Remeasurements—difference between IASB/FASB?
IFRS: Recognised in OCI and never subsequently amortised to P&L.
Net return on plan assets = actual return - (plan assets * interest rate)
Actuarial gains and losses = changes in pension obligation arising from changes in actuarial gains and losses
GAAP: Recognised immediately in P&L, then recognised in OCI and subsequently amortised to P&L using corridor method.
Difference between expected and actual return on assets = Actual return - (plan assets * expected return)
Actuarial gains and losses = Changes in a company's pension obligation arising from changes in actuarial assumptions
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What is the corridor approach?
A US GAAP method for DB pensions. Net cumulative unrecognised actuarial gains/losses is compared with defined benefit obligation and FV of plan assets. If unrecognised actuarial gains/losses exceeds 10% of DBO or FV of plan assets, the excess is recognised in OCI and amortised to P&L over expected average remaining working lives of employees and is included as component of periods pension cost in P&L.
Entities can choose to amortise more quickly if they wish.
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What are the IASB/FASB differences between presenting periodic pension cost?
IFRS: does not specify where to present components of periodic pension cost. May present separately.
US GAAP: must agggregate components of periodic pension cost and present net in a single line item.
Pension costs included in the cost of production of goods may be capitalised as part of valuation of ending inventory. Eventually this would go out through COGS.
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What is the projected unit credit method?
An actuarial valuation method in IFRS used to determine the PV of its defined benefit obligations and related current service cost and, where applicable, past service cost. Each period of service gives rise to an additional unit of benefit to which the employee is entitled at retirement.
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How to calculate ending salary that has increased by x% over x years?
Final year's estimated salary = Current year's salary * [(1 + annual compensation increase)^years until retirement]
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How to reclassify pension expense components between operating and non-operating income for analytical purposes?
1) Adjust operating income by adding back full amount of pension expense, and subtracting the service costs
2) Increase interest expense reported by the interest expense component of pension cost
3) Increase interest/investment/other income by Actual return on plan assets
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How is the cash flow impact of pensions adjusted for?
If contributions exceed pension costs, excess economically reduces pension obligation.
If contributions are less than pension cost, can view as a source of financing.
Remove from CFO and add to CFF.
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How to calculate the total pension cost for period?
Periodic pension cost = ending funded status - employer contributions - beginning funded status
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How is share-based compensation reported?
Share-based compensation should be expensed during period employees earn that comp. Comp expense is measured at FV of share-based comp granted at grant date. That amount should be allocated over the employee service period.
For stock grants the comp expense is based on FV of stock.
For options you need to use a pricing model to get to the FV.
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What is 'functional currency'?
The currency of the primary economic environment in which the entity operates. (IAS 21.8).
Vs, 'presentation currency' as the currency in which the parent entity reports its FSs
and 'local currency' being the national currency
'Foreign currency' is any currency other than the functional currency.
A foreign currency transaction should be recorded in the functional currency at initial recognition, by applying spot exchange rate to foreign currency amount. (IAS 21.21)
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What is foreign exchange risk?
ie 'transaction exposure'
The exposure to changes in exchange rates between transaction date and payment date.
Both IFRS and US GAAP require change in value of FC A/L (eg account receivable in a FC) to be treated as gain/loss in net income (even if the gains/losses have not been realised).
Unrealised FC transaction gains/losses are included in net income when the balance sheet date falls between the transaction and settlement dates.
This is one of the few situations in which accounting allows companies to recognise a gain/loss in income before it has been realised.
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Where are foreign currency transaction gains/losses reported?
Accounting standards don't indicate where in income statement they should go. Companies generally choose either as a component of other operating income/expense, or non-operating income/expense.
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What are the two translation methods used to translate foreign subsidiary FSs into the parent's presentation currency for consolidated statements?
Current rate method: ALL A/L translated at current exchange rate, equity items translated at historical exchange rates, and revenues/expenses translated at rate that existed when the transaction occurred. For practical reasons, an average exchange rate is often used.
Used when subsidiary has a functional currency different from the parent's presentation currency. Cumulative translation adjustment accumulated in equity.
Temporal method: ONLY MONETARY A/L (and non-monetary A/L at FV) are translated at current exchange rate. Non-monetary A/L not measured at FV and equity items are translated at historical exchange rate. Revenues/expenses, other than those expenses related to non-monetary assets, are translated at exchange rate that existed when transaction occurred. Expenses related to non-monetary assets are translated at the exchange rates used for the related assets.
Used when subsidiary has a functional currency that is the same as the parent's presentation currency. Cumulative translation adjustment included as a gain/loss in income.
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How to determine what translation method is used to translate foreign subsidiary FSs into the parent's presentation currency for consolidated statements?
Current rate method: Used when subsidiary has a functional currency different from the parent's presentation currency. Cumulative translation adjustment accumulated in equity.
Temporal method: Used when subsidiary has a functional currency that is the same as the parent's presentation currency. Cumulative translation adjustment included as a gain/loss in income.
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What is the current rate method?
Used when subsidiary has a functional currency different from the parent's presentation currency. Cumulative translation adjustment accumulated in equity.
1) ALL A/Ls translated at current ER at BS date.
2) Equity translated at historical ERs.
3) Revenue/expenses translated at ER that existed when transactions took place. (can use average).
Results in a net asset BS exposure (assets typically > liabilities), therefore when foreign currency strengths, there is a positive translation adjustment.
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What happens to stockholders' equity in the temporal and current rate method?
Stockholders' equity accounts are translated at historical exchange rates under both the current rate and the temporal methods.
Net income in FC (foreign currency) - Dividends in FC = RE in FC
RE in FC * exchange rate when dividends declared = RE in PC (presentation currency)
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What is balance sheet exposure?
A net asset BS exposure is created when assets translated at current ER are > liabilities translated at current ER. If it strengths, it's a positive translation adjustment, and if it weakens it's a negative translation adjustment.
The opposite is a net liability BS exposure. If a liability BS exposure strengthens it's a negative translation adjustment.
Current rate method results in a net asset BS exposure.
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What is the temporal rate method?
Used when subsidiary has a functional currency that is the same as the parent's presentation currency. Cumulative translation adjustment included as a gain/loss in income.
1) MONETARY A/Ls translated at current ER
1a) NON-MONETARY A/Ls at FV translated at date when FV was determined
1b) NON-MONETARY A/Ls measured at historical cost translated at historical ER
2) Equity translated at historical ERs
3) Revenue/expenses translated at ER that existed when transactions took place. (can use average).
3a) Expenses related to non-monetary assets, eg COGS, depreciation/amortisation, translated at ER used to translate related assets.
Generates a net asset or net liability BS exposure, depending on whether assets translated at current ER are > or < liabilities translated at current ER.
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How is translation done in highly inflationary economies?
IFRS: Must first restate FSs for local inflation using procedures in IAS 29 (Financial Reporting in Hyperinflationary Economies), then the inflation-restated foreign currency FSs are translated into the parent's presentation currency using the foreign exchange rate.
BS:
- monetary A/Ls not restated because they are already expressed in monetary units
- non-monetary A/Ls restated for inflation. apply change in price index from date of acquisition to the historical cost (or revalued amount).
- equity is restated by applying change in price level from beginning of period.
IS:
- all IS items restated by applying change in price level from when items were originally recorded
- net gain/loss in purchasing power that arises from monetary assets/liabilities during period of inflation is included in net income
US GAAP: translate foreign currency FSs as if parent's currency is the functional currency. (ie foreign currency FSs are translated using the temporal method, with no restatement for inflation).
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How are three different hedge types reported?
Fair value hedge: Gains/losses (effective and ineffective) recognised in income statement.
Cash flow hedge: Gains/losses (effective) reported in OCI (equity). Gains/losses (ineffective) reported in income statement.
Net investment hedge of foreign subsidiary: Gains/losses (effective and ineffective) recognised in OCI (equity).
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Are cash or accrual earnings more persistent?
Accrual component of income is less persistent (ie more transitory) than the cash component. Persistency is one dollar today being worth one dollar tomorrow.
An analyst should apply a lower multiple to accrual component than cash component when valuing performance.
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What are the four accruals?
ASSETS:
-Accrued revenue: revenue has been earned, but cash hasn't been collected. (accounts receivable)
-Deferred expenses: cash paid but goods/services haven't been received. (prepaid expense)
LIABILITIES:
-Unearned (deferred) revenue: cash is received prior to providing goods/services.
-Accrued expenses: expenses have been incurred, but cash not yet paid. (accounts payable)
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How to compute balance sheet-based aggregate accruals (balance sheet approach)?
Aggregate accruals_bs = Net operating assets_end - Net operating assets_beg
```
OA = total assets - cash+cash equivalents
OL = total liabilities - total debt
```
NOA = OA - OL
We can scale this to get a BS-based accruals ratio.
accruals ratio_bs = (NOAend - NOAbeg) / [(NOAend + NOAbeg) / 2]
Companies with high (low) accruals ratios have low (high) earnings quality.
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How to compute cash flow-based aggregate accruals (cash flow approach)?
Aggregate accruals_cf = Net income - CFO - CFI
accruals ratio_cf = (NI - CFO - CFI) / [(NOAend + NOAbeg) / 2]
```
OA = total assets - cash+cash equivalents
OL = total liabilities - total debt
```
NOA = OA - OL
Companies with high (low) accruals ratios have low (high) earnings quality.
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How to compare revenue to cash collections?
Revenue = cash collected + increase in A/R - increase in unearned revenue
Revenue - cash collected = increase in A/R + write offs of A/R (decrease in allowance for doubtful accounts) - increase in unearned revenue
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How is days sales outstanding (DSO) used to evaluate revenue quality?
DSO measures days it takes to convert receivables into cash. An increasing DSO may indicate lower quality revenue.
DSO = (net accounts receivable / revenue) * 365
>>CFA definition
DSO = accounts receivable / (revenue / 365)
DSO = 365 / Receivables turnover
Receivables Turnover = Net receivable sales / Average net receivables
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How to detect accelerated revenue by comparing revenue to cash collected?
cash collections = revenue - increase in receivables + increase in unearned revenue
Unearned (deferred) revenue: cash is received prior to providing goods/services.
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How to detect understated expenses with days inventory on hand (DOH)?
An increasing DOH (Days inventory outstanding) may indicate obsolete inventory.
DOH = # of days in period / inventory turnover
inventory turnover = COGS / avg inventory
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How to detect misclassification of operating expenses as nonrecurring or nonoperating with the core operating margin?
Core operating margin measures the pretax return on the monetary unit of sales from the firm's operations.
COM = (sales - COGS - SG&A) / sales
Analysts should compare changes in the COM over time and look for negative nonrecurring or nonoperating items that occurred when the ratio increased.
A large increase in COM along with a negative special item or nonrecurring item may indicate an opportunistic reclassification of of a recurring item as a nonrecurring item.
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What is the DuPont equation to calculate Return on Equity?
ROE = (net income / EBT) * (EBT / EBIT) * (EBIT / revenue) * (revenue / assets) * (assets / equity)
NB first three terms are disaggregated net profit margin
Tax burden = net income / EBT
Interest burden = EBT / EBIT
EBIT Margin = EBIT / revenue
Asset turnover = revenue / avg assets
Financial leverage = assets / equity
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Cash conversion cycle
days sales outstanding + days inventory on hand - number of days payables
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Number of days payables
365 / payables turnover (payables turnover = purchases / avg trade payables)
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Days of sales outstanding
365 / receivables turnover; (receivables turnover = sales / avg receivables)
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Days of inventory on hand
365 / inventory turnover; (inventory turnover = COGS / avg inventory)
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How is cash flow affected by choosing between LIFO and FIFO?
FIFO generally results in higher EBIT (because COGS is lower). Hence tax expense is higher, and cash is lower than would be under LIFO.
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Asset turnover
revenue / avg assets
