CFA L2 FSA Part (1/2)

Question 1

Categories of intercorporate (involving two or more firms) investments in marketable securities:

Answer 1

• Investments in financial assets
• Investments in associates
• Business combinations

Question 2

Investments in financial assets

Answer 2

When the investing firm has no significant control over the operations of the firm it’s investing in. These are considered passive investments. How to classify: An ownership interest of less than 20% is usually considered a passive investment. In this case, the investor cannot significantly influence or control the investee.

• Accounting treatment: Amortized cost or fair value

Question 3

Investments in associates

Answer 3

When the investing firm has significant influence over the firm it’s investing in (called associates), but not control. With GAAP, these are often referred to as affiliates. How to classify: An ownership interest between 20% - 50% is typically a noncontrolling investment

• Accounting treatment: Use the equity method to account for investments in associates.

Question 4

True or false: Every investment > 20% has significant control of the investee and every investment < 20% has no significant control?

Answer 4

False, investments > 20% may have no significant control over the investee. In this case, these investments are considered investments in financial assets. Conversely, investments < 20% may have significant control over the investee. In these cases, these are classified as investments in associates.

Question 5

Ways that firms that perform investments in associates can exhibit influence:

Answer 5

• BOD representation.
• Involvement in firm policy making.
• Transactions between the investor and investee.
• Interchange of key personnel
• The investee is technologically dependent on the investing firm.

Question 6

Business combinations

Answer 6

When the investing firm has control over the firm it’s investing in, called a subsidiary. How to classify: An ownership interest of more than 50% is usually a controlling investment. When the investor can control the investee, the acquisition method is used.

• Accounting treatment: Use the acquisition method to account for business combinations.

Question 7

True or false: All firms that control 50% of another company have control over the investee?

Answer 7

False, it’s possible to own 50% or more of a business and not have control. For example, control can be temporary or barriers may exist such as bankruptcy or governmental intervention. These would be investments in associates. Oppositely, it’s possible to own < 50% of a business and have control. These are considered business combinations.

Question 8

Joint venture

Answer 8

An entity that is controlled by two or more investors.

• Accounting treatment: Both IFRS and GAAP require the equity method for joint ventures. In rare cases, IFRS and GAAP allow proportionate consolidation as opposed to the equity method.

Question 9

IFRS accounting terms for how financial assets are held synonymous with GAAP accounting terms:

Answer 9

IFRS: amortized cost = GAAP: held-to-maturity
IFRS: Fair value through profit or loss = GAAP: tradable securities
IFRS: Fair value through OCI = GAAP: available-for-sale

Question 10

Amortized cost classification

Answer 10

1/3 IFRS treatments for financial assets. Used for debt securities only. This treatment should be used if the debt security is intended to be held until it matures. These debt securities are reported on the balance sheet at amortized cost. This is where the security is initially listed at its purchase price on the b/s, but then any premiums/discounts are amortized over time towards their par values. The amortization of premiums/discounts and any interest income is accounted for in the IS.

• Two criteria must be met to be classified as amortized cost: (1) Business model test= Debt securities are being held to collect contractual cash flows. (2) Cash flow characteristic test= The contractual cash flows are either principal, or interest on principal, only.

Question 11

Fair value through profit or loss (FVPL) classification

Answer 11

1/3 IFRS treatments for financial assets. Debt securities can be classified as FVPL if held-for-trading or if accounting for those securities at amortized cost results in an accounting mismatch. Equity securities that are held-for trading MUST be held as FVPL. Any other equity security can be classified as FVPL or FVOCI. Derivatives that are not used for hedging are always carried at FVPL. If an asset has an embedded derivative (ex: convertible bonds), the asset as a whole is valued at FVPL. FVPL securities are reported on the balance sheet at fair value. The changes in fair value, both realized and unrealized, are recognized in the IS along with any dividend or interest income.

Question 12

Fair value through OCI (FVOCI)

Answer 12

1/3 IFRS treatments for financial assets. Debt or equity securities that are listed on the b/s initially at fair value. Any unrealized gains/losses are accounted for as OCI in equity. Interest income and dividend income is accounted for in the IS. If sold, realized gains/losses are accounted for in the IS.

Question 13

True or false: Under all three methods of classification, interest income for debt securities is always treated the same?

Answer 13

True, under all 3 methods it’s coupon payment + amortized discount OR coupon payment - amortized premium.

Question 14

True or false: For equity securities, companies can change the classification from FVPL to FVOCI at any time?

Answer 14

False, once initially chosen it’s irrevocable.

Question 15

True or false: For debt securities, companies can change the classification from amortized cost to FVPL (or vice versa) at any time?

Answer 15

False, it CAN change but only if the business model changes.

Question 16

How to go from FVPL into amortized cost

Answer 16

Debt securities that are reclassified out of FVPL into amortized cost are transferred at fair value on the date of reclassification, and that fair value will become the carrying amount meaning if there is a difference between the FV at the date of reclassification and the par value, the differences will be amortized.

Question 17

How to go from amortized cost to FVPL

Answer 17

URL/URG carried at amortized cost is recognized in the IS once transferred to FVPL.

Question 18

Expected credit loss model

Answer 18

Requires companies to evaluate historical, current, and forward looking prospects in regards to loans and leases.

Question 19

How to calculate amortization:

Answer 19

(PV price * yield) - (FV * coupon rate). Under amortized cost, both the b/s value and IS will rise by this amount. (Note, the IS will also rise by any interest income)

Question 20

How to calculate the impact to the IS for a security classified as FVPL if the security is sold prior to maturity:

Answer 20

Selling price - FV
OR
We need to calculate net gain = reversal of any unrealized gains (subtract URG) or unrealized losses (add back URL) +/- realized gains/losses

Question 21

Equity method

Answer 21

The accounting treatment for investments in associates. The initial investment is recorded at the purchase price and listed on the b/s as a noncurrent asset. In subsequent periods, increases in the investee’s earnings proportionately increase the investment account on the investor’s b/s and increase the investor’s IS. Dividends received from the investee DO NOT impact the investor’s IS and reduce the investment account on the investor’s b/s since it’s considered a return of capital. The opposite is true if the investee records a loss.

Impact on b/s: B/S value = purchase price +/- (earnings * share of company) - (dividends * share of company)
Impact on IS: +/- earnings * share of company
Investor CF received: dividends * share of company

Question 22

What happens if the investee’s losses reduce the investor’s investment account to zero?

Answer 22

The equity method is discontinued until the proportionate share of the investee’s earnings exceed the share of losses that were not recognized during the suspension period.

Question 23

Fair Value Option for Equity Method

Answer 23

Under GAAP, firms have the right to choose whether investments in affiliates (associates) are recorded at fair value. Under IFRS, the fair value option is only available to venture capital firms, mutual funds, and similar entities. The decision to use the fair value option is irrevocable and any changes in value (along with dividends) are recorded in the income statement.

Question 24

True or false: Typically the price paid for an associate/affiliate = the BV of its assets?

Answer 24

False, since most of the investee’s assets will be valued at historical cost.

Question 25

Goodwill

Answer 25

The excess of the purchase price over the net fair value of a company’s assets at the acquisition date. Goodwill is not amortized but must be tested for impairment at least ANNUALLY. If impaired, goodwill is reduced and a loss is recognized on the income statement.

Question 26

How to calculate goodwill under the equity method

Answer 26

Purchase price - (bv of assets * share of company) - [ (the discrepancy of any assets w/ different fair values than book values (fair value - book value)) * share of company ]

Question 27

How to calculate NI of investor under the equity method w/ goodwill

Answer 27

(net income of investee * share of company) - (any adjustment made to the fair value at the date of acquisition * share of company)

Question 28

How to calculate impact to investor’s b/s under the equity method w/ goodwill

Answer 28

% acquired ÷ (book value of net assets at beginning of year + net income ÷ dividends) + unamortized excess purchase price

Question 29

How are impairments treated for equity method investments under IFRS and GAAP?

Answer 29

Equity method investments must be tested for impairment. Under GAAP and IFRS: if FV falls below carrying value and the decline is other-than-temporary, the investment is written down and the loss is recognized in the IS. IFRS needs clear evidence of loss in value: loss event, impact on FCFs, or some sort of reliable measurement shows there is loss.

Question 30

True or false: Impairments for equity method investments under IFRS and GAAP can be written up in the future if there is a recovery in value?

Answer 30

False, neither IFRS nor GAAP allows for the asset to be written up at any point in time.

Question 31

Upstream transactions w/ associates/affiliates vs downstream

Answer 31

Upstream: Investee to investor. Any profit on a transaction is in the investee’s account. But, if the goods have not been used/sold by the investor, the investor’s income statement will not be increased by (investee’s earnings * share of company). The investor must eliminate its proportionate share of the profit from the income of the investee.
Downstream: Investor to investee. Any profit on a transaction is in the investor’s account. The same concept as upstream transactions apply here. The investor must eliminate the proportionate share of the profit.

Question 32

Upstream transaction example

Answer 32

An investor owns 30% of the investee. During the year, the investee sold $15k in goods to the investor, however, at year end, the investor had 50% of these goods still in inventory. What is the impact to the investor’s IS?
(15k * .5) * .3 = 2,250 increase in earnings

Question 33

Downstream transaction example

Answer 33

An investor owns 30% of the investee. During the year, the investor sold $40k in goods to the investee for $50k. The investee sold 90% of the goods by year-end. What is the impact to the investor’s IS?
Investor profit = $50k - $40k = $10k. 10% of goods remain in investee’s inventory, thus investor must reduce income by proportionate share: ($10k * 10%) * 30% = $300 decrease in profit for investor. So total profit = $10k - $300 = $9.7k

Question 34

True or false: If an investee is highly profitable but has a dividend payout < 100%, the equity method usually results in lower earnings as compared to the accounting methods for investments in financial assets?

Answer 34

False, it usually results in higher earnings.

Question 35

True or false: Since the investor reports its proportionate share of the investee’s equity in only one line, the investor’s leverage will be lower since debt is ignored and margin ratios will be higher since investee’s revenues are ignored?

Answer 35

TRUE

Question 36

GAAP categories of business combinations:

Answer 36

• Merger
• Acquisition
• Consolidation

• IFRS does not distinguish between different types of combinations. Both GAAP and IFRS only use the acquisition method to account for business combinations.

Question 37

Pooling-of-interests method/ uniting-of-interests method

Answer 37

IFRS previously used this method to account for business combinations, however it is NOW EXTINCT. This method combined the assets and liabilities of two firms and viewed each firm as equal.
Key attributes of this method:
* Firms are combined using historical BVs.
* Operating results from prior periods are restated as though the two firms were always combined.
* Ownership interests continue.

Question 38

Steps to acquisition method in regards to the b/s

Answer 38

Record any finance (debt or equity) raised by the parent for the acquisition in the parent’s b/s. If cash was used for the acquisition, reduce parent’s cash by the amt spent and list the investment as an asset at purchase price. This is all in the parent’s b/s. Do not include the investment line item in the parent’s b/s. Create minority interest: share of equity not owned. This obviously will not exist when a company acquires 100% of a company. Calculate goodwill. Combine 100% of assets and liabilities of both firms, after netting out intercompany transactions.

Question 39

Minority interest/ noncontrolling interest calculation

Answer 39

% of subsidiary not acquired * (subsidiary’s post-acquisition net assets (assets - liabilities))

Question 40

Partial goodwill calculation

Answer 40

Purchase price - [ % of subsidiary acquired * (subsidiary’s post-acquisition net assets) ]

Question 41

Steps to acquisition method in regards to the IS

Answer 41

1. Combine the post-acquisition revenues of the parent and subsidiary.
2. Combine the post-acquisition expenses of the parent and subsidiary.
3. Create a minority interest item: (% of subsidary not owned * subsidary’s post-acquisition NI) NI= #1 - #2 - #3

Question 42

True or false: The acquisition method results in lower revenues and expenses than the equity method?

Answer 42

False, the acquisition method results in higher revenues and expenses (since the parent and subsidiary are combined) but the NIs will be equal under the acquisition method and the equity method.

Question 43

What is partial goodwill

Answer 43

This is how we account for goodwill when there is an acquisition of less than 100% of the subsidiary. ONLY IFRS ALLOWS PARTIAL GOODWILL.

• IFRS gives firms the option to report full goodwill or partial goodwill.

Question 44

GAAP full goodwill calculation (required by GAAP ; allowed by IFRS)

Answer 44

fair value of the subsidiary (purchase price) - fair value of the subsidiary’s identifiable NET assets.

Question 45

IFRS partial goodwill calculation (only allowed by IFRS)

Answer 45

purchase price - (% owned * FV of the subsidiary’s NET identifiable assets)
OR
(% owned * full goodwill)

Question 46

True or false: Goodwill is an identifiable asset?

Answer 46

FALSE

Question 47

Identifiable intangible assets

Answer 47

Intangible assets that can be acquired separately. These assets can be amortized over their useful lives. Ex: Patents, copyrights.

Question 48

Unidentifiable intangible assets

Answer 48

Intangible assets that cannot be acquired separately and may have an unlimited life. Cannot be amortized over their useful lives. Tested for impairment annually. Ex: Goodwill

Question 49

True or false: The value of noncontrolling interest depends on whether full goodwill or partial goodwill is used?

Answer 49

True

Question 50

Noncontrolling interest under full goodwill calculation

Answer 50

(% not owned) * (purchase price)

Question 51

Noncontrolling interest under partial goodwill calculation

Answer 51

% not owned * (FV of net identifiable assets of the subsidiary)

Question 52

True or false: The partial goodwill method results in higher total assets and higher total equity than the full goodwill method?

Answer 52

False, the full goodwill method results in higher total assets and higher total equity than the partial goodwill method.

Question 53

Impairment

Answer 53

When carrying value > fair value

• Impairment is reported as a line item on the IS.

Question 54

True or false: Goodwill impairments can be reversed after six months?

Answer 54

False, goodwill impairments cannot be reversed.

Question 55

Testing for impairment of goodwill under GAAP vs IFRS

Answer 55

GAAP requires potentially a two step approach. First, determine if carrying value (including goodwill) > FV of the subsidiary; if so, impairment exists. Second, the loss reported in the IS is the difference between the carrying value of goodwill and the implied FV of goodwill. The loss is a part of continuing operations. Implied fair value calculation: FV of subsidiary - FV of subsidiary’s net assets.
IFRS requires a one step approach. If the carrying value (including goodwill) > FV of the subsidiary, reduce goodwill by this difference and create a one time expense of the difference in the IS. The loss is considered an extraordinary item in the IS.

Question 56

Recoverable amount

Answer 56

The higher of (selling price - cost) or (value in use)

• Value in use= PV of FCFs

Question 57

What to do if the impairment loss is greater than the carrying value of goodwill?

Answer 57

IFRS: Eliminate goodwill down to 0 and if the loss is still more, reduce the value of noncash assets
GAAP: Eliminate goodwill down to 0 and if the loss is still more, forget about the excess.

Question 58

Bargain purchase

Answer 58

When the purchase price is less than the fair value of the subsidiary’s net assets.

How to account for this: Both IFRS and GAAP require that the difference between purchase price and fair value of net assets be recognized as a gain in the parent’s IS.

Question 59

Proportionate consolidation method

Answer 59

A method of accounting for joint ventures that is seldom allowed under IFRS and GAAP. This method is similar to the acquisition method, except the investor only reports the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. Sine the proportionate share is reported, no minority interest is needed.

Question 60

Proportionate consolidation assets example:
Company A acquires 80% of Company B for $8,000 cash. What is the affect to the b/s?
Company A has $48,000 in CA and $32,000 in other assets. Company B has $16,000 in CA and $8,000 in other assets.

Answer 60

1. For the group account (consolidated account), take $40,000 + ($16,000 * .8) = $52,800.
2. For the group account, take the $32,000 in company A’s other assets and add company B’s ($8,000 * .8) = $38,400.
3. Add the group account’s CA + other assets= $91,200.

Question 61

True or false: With the proportionate consolidation method, in the group account we only include the subsidiary’s common stock and the subsidiary’s R/E?

Answer 61

False, in the group account we include the parent’s common stock and the parent’s R/E. The difference between this and the equity method is that the CL is the parent’s + their proportion of the subsidiary’s.

Question 62

True or false: With the equity method, in the group account we only include the subsidiary’s CL, common stock, and R/E? The parent’s isn’t included.

Answer 62

False, under the equity method, only the parent’s CL, common stock, and R/E is included in the group account. Recall, post acquisition earnings include the parent company’s R/E + the parent’s share of earnings from the joint venture.

Question 63

True or false: With the proportionate consolidation method, revenues and expenses are the parent company’s revenues/expenses + their proportionate share of the subsidiary’s revenues/expenses?

Answer 63

True

Question 64

True or false: Net income and revenues are higher under the equity method but expenses are lower compared to the proportionate consolidation method.

Answer 64

False, net income under the equity method and proportionate consolidation method is the same but revenues and expenses are different. THIS DISTORTS RATIOS.

Question 65

Joint venture vs joint operation

Answer 65

A joint venture is a separate legal entity. We use equity accounting in this situation.
Joint operation is doing business with another company but it’s not a separate legal entity. Here, we use proportionate consolidation method.

Question 66

Special Purpose Entity (SPE)/ Special Purpose Vehicle (SPV)

Answer 66

A legal structure in the form of a separate business entity created by a parent company to isolate certain assets and liabilities. This is often used to reduce financial risk. SPEs can be in the form of corporations, partnerships, joint ventures, or trusts. Typically, the parent company controls the finances/operations of the SPE, while a third party has controlling interest over the equity. Typically the motivation of an SVE is low-cost financing. The SVE can often borrow at lower rates.

Question 67

Mechanics of an SPE

Answer 67

A parent company sells an asset to the SPE and the SPE pays cash to the parent company. The SPE acquires the cash by issuing ABSs.

Question 68

Variable interest entity (VIE)

Answer 68

VIEs only exist under GAAP. An SVE that has at-risk equity that is insufficient to finance the entity’s activities w/o additional financial support or equity investors that lack decision making rights, the obligation to absorb expected losses, or the right to receive expected residual returns.

Question 69

True or false: Prior to Enron scandals, a company under GAAP could create an SPE and if they owned less than 50% of the entity, they did not have to consolidate?

Answer 69

True, this changed after Enron to where now companies must consolidate if they can share in the reward. IFRS always made companies consolidate if they had anything to benefit from.

Question 70

Synthetic leases

Answer 70

A type of SPE. This is where a sponsoring company (parent company) sells off some of its PP&E to the SPE and then immediately lease it back immediately. The lease is then classified as an operating lease, which recall from L1, is any lease where both the benefits and risks are not substantially transferred. This is often used to boost the d/e ratio.

Question 71

Securitized loan

Answer 71

A type of SPE. This is where loans/mortgages are sold to an SPE which issues MBSs.

Question 72

Sales of receivables

Answer 72

A type of SPE. This is where a parent company sells accounts receivable to the SPE which then uses the receivables as collateral to borrow.

Question 73

R&D cost

Answer 73

A type of SPE. This where an SPE is established to fund R&D w/o having to recognize R&D expense or liabilities in the group accounts. This only works if the companies aren’t consolidated.

Question 74

Conditions where a parent company and SPE must consolidate under IFRS:

Answer 74

• SPE is for benefit of the parent company.
• Parent company has decision-making power.
• Parent company is able to absorb risks/rewards.
• Parent company has residual interest.

Question 75

Conditions where an SPE is considered a VIE, and thus must be consolidated under GAAP:

Answer 75

• Insufficient at-risk investment (typically less than 10% of equity capital): The theory here is that since the SPE doesn’t have a lot of equity, if it starts to lose money it’ll need a bail out from the parent company.
• Shareholders lack decision-making rights.
• Shareholders do not absorb expected losses.
• Shareholders do not receive expected residual returns.

Question 76

Today, there are still substantial accounting benefits from use an SPE?

Answer 76

FALSE

Question 77

True or false: When the receivables are securitized, the sponsor removes the receivables from the balance sheet and reports the cash inflow as an operating activity in the cash flow statement?

Answer 77

True

Question 78

Under IFRS, how are contingent assets and contingent liabilities recognized during an acquisition?

Answer 78

Contingent assets= never recognized.
Contingent liabilities= For the contingent liabilities that can be measured reliably at MV, recognize these at the time of acquisition. In subsequent periods, contingent liabilities are measured at the higher of the value initially recognized or the best estimate of the amount needed to settle the liabilities.

Question 79

Under GAAP, how are contingent assets and contingent liabilities recognized during an acquisition?

Answer 79

GAAP divides these two things into contractual and noncontractual. Contractual contingent assets and liabilities are recorded at FV on their acquisition date. Noncontractual contingent assets and liabilities are recorded if they are PROBABLE to happen.

Question 80

Under IFRS, how are identifiable assets and liabilities recognized during an acquisition?

Answer 80

They are recorded at FV. The acquirer must recognize the assets and liabilities that the firm being acquired had not recognized.

Question 81

How to recognize a contingent consideration (a sum of money to be paid if a firm hits a certain earnings target) during an acquisition under IFRS and GAAP?

Answer 81

The asset, liability, or equity is recognized at its best estimated FV. Any changes in value of liabilities affect the IS unless the item is an equity item where then it would settle within equity, not the IS. Under GAAP, any changes in the fair value of a contingent consideration considered an asset affect the IS.

Question 82

How to recognize in-process R&D during an acquisition under IFRS and GAAP?

Answer 82

In-process R&D is capitalized as an intangible asset and included as an asset under both GAAP and IFRS. It is subsequently amortized (if successful) or impaired (if unsuccessful).

Question 83

How to recognize restructuring costs during an acquisition under IFRS and GAAP?

Answer 83

Restructuring costs are expensed when incurred and not capitalized as part of the acquisition under IFRS and GAAP.

Question 84

Effects to the b/s and IS from the choice of equity method, proportionate consolidation method, or acquisition method:

Answer 84

All 3 methods report the same NI. The equity method and proportionate consolidation method report the same equity but the acquisition method’s will be higher. Assets and liabilities are highest under the acquisition method and lowest under the equity method. Revenues and expenses are highest under the acquisition method and lowest under the equity method.

Question 85

4 types of compensation:

Answer 85

• Short-term= less than 12 months (ex: salary)
• Long-term= more than 12 months (ex: long-term disability)
• Stock-based: options or stock grants
• Post-retirement

Question 86

Vesting period

Answer 86

Difference between the time the stock grant is granted to the employee (offering date) and the time until an employee can sell the stock. This is the schedule over which you gain ownership of various benefits.

• For salaries: two weeks
• For stock options: several years (typically)

Question 87

Share-based compensation

Answer 87

When employees are paid with a company’s shares versus cash.
Advantages:
* No cash outlays for the firm
* Aligns mgmt and shareholder interests.

Disadvantages:
* Dilutes the shares of existing shareholders
* Since employees’ actions minimally affect the share price their motivation to work hard is limited
* Managers may take too much risk if their pay is tied to company performance. If stock is guaranteed, managers may take too little risk.

Question 88

Stock grants

Answer 88

Stock grants occur when the company pays part of the compensation of the employees in the form of corporate stock. Stock grants often have specific conditions attached for the grants to vest.

Accounting treatment: The value of the stock grant is expensed during the vesting period and put in a reserve under equity. Expense= MV at grant date. Upon settlement, the reserve is removed and allocated to common stock and paid-in capital.

Question 89

Value of stock grant calculation

Answer 89

Value of stock on grant date * # of shares granted

Question 90

Restricted vs unrestricted stock grants

Answer 90

Restricted: Most of the time, stock grants have some restriction. The most common restriction is a service condition: the # of years until an employee is vested (able to sell the stock), this creates an incentive to stay with the company. Another common condition is a performance condition: where the grant vests upon completion of some performance achievement or market condition (ex: stock price).

Unrestricted: There are no conditions.

Question 91

Restricted stock units (RSU)

Answer 91

Similar to performance shares, but unlike performance shares, RSUs are traded for stock when they vest, not upfront at the time of the achievement. If an employee quits prior to vesting, the ownership will be returned to the company. RSUs do not accrue dividends. RSUs are preferred over stock options by employees because they accrue some value if stock price > 0.

Value of RSU calculation: (Value of stock on grant date * # of shares granted) - (dividends accrued during the vesting period).

• When you’re granted stock options, you literally have the “option” to purchase company stock at a specific price before a certain date. Whether, and when, you actually purchase the stock is entirely up to you. RSUs, on the other hand, grant you the stock itself once the vesting period is complete
• The key difference between performance stock and RSUs is in how vested shares are calculated. With restricted stock, the company agrees to grant a set number of shares regardless of company performance. The number of shares granted in a performance stock program fluctuates depending on the performance of your company.

Question 92

Share-based compensation required disclosures in footnotes:

Answer 92

• Nature and extent of share-based compensation during the period.
• How MV was determined.
• Impact on income for the period.

Question 93

Stock options for employee compensation

Answer 93

Stock options give the employee the right but not the obligation to buy a set amount of the company’s stock at a set price within a specified time frame. Stock options are always subject to vesting schedules. In most instances, option agreements expire once an employee leaves the company, incentivizing an employee to stay. Stock options are non-tradeable call options. If the stock price > exercise price, the employee can exercise the option and earn the difference. If stock price < exercise price, the employee won’t exercise. Fair value at grant date= estimated option premium. Service period= difference between grant date and vesting date (first date the options may be exercised).

Accounting treatment: Expense is based on FV at grant date. Expense is then allocated straight line to the IS over the vesting period.

• Options and stock grants do not result in a liability.
• The tax benefits from employee stock options affect CFF.

Question 94

How to determine FV of a stock option

Answer 94

If there is a similar option, the FV of that similar option can be used. Otherwise, an option-pricing model (such as Black-Scholes) is used. IFRS and GAAP do not mandate a specific kind of model.

Question 95

Stock Option/Grant Example:

Firm A has an employee stock option and RSU grant plan for its sr mgmt. On January 1, the firm granted 2MM at-the-money options and 1MM shares. The FV of the options was $2.85 and the stock price on the date of the grant was $23. Both awards vest over 4 years. What’s the annual expense for the options/grants?

Answer 95

Annual expense for options: (2MM * $2.85)/4= $1,425M
Annual expense for grants: (1MM * $23)/4= $5,750M
Total annual expense for options/grants= ($5,750M + $1,425M)= $7,175M.

Question 96

True or false: The money set aside in the reserve will offset the reduction to NI and thus retained earnings when a stock grant/option is paid out?

Answer 96

TRUE

Question 97

Tax deduction for stock grants:

Answer 97

Only accounted for at settlement.

Calculation: share price at settlement date * # of shares vested

Question 98

Tax deduction for stock options:

Answer 98

Only accounted for at settlement.

Calculation: exercise value * # of options vested
OR
(stock price on settlement date - strike price) * # of options

Question 99

Excess tax benefit/ tax windfall

Answer 99

When the stock price on the settlement date > the stock price on the grant date, the tax deduction will be higher than the cumulative tax compensation expense.

• Tax windfalls reduce tax expense in the income statement.

Question 100

Tax shortfall

Answer 100

When the stock price on the settlement date < the stock price on the grant date, the cumulative tax compensation expense is higher than the tax deduction.

• Tax shortfalls increase tax expense in the income statement.

Question 101

True or false: Under IFRS, tax windfalls and shortfalls are reported under equity, while under GAAP, tax windfalls reduce tax expense in the IS and tax shortfalls increase tax expense in the IS?

Answer 101

TRUE

Question 102

Dilutive vs antidilutive securities

Answer 102

Dilutive securities= Securities that increase the # of common shares if exercised and thus reduce EPS. (Ex: convertible stock)
Antidilutive securities= Securities that would increase EPS if exercised or converted to common stock.

Question 103

True or false: Performance shares that vest based on a period of service are usually considered antidilutive if the stock price has not declined substantially?

Answer 103

False, performance shares that vest based on a period of service are usually considered dilutive if the stock price has not declined substantially.

Question 104

True or false: Unvested options that are in-the-money are considered antidilutive?

Answer 104

False, dilutive

Question 105

RSUs and restricted stock grants are normally dilutive but if the current stock price is significantly less than the price on the grant date, they are antidilutive?

Answer 105

TRUE

Question 106

Treasury stock method

Answer 106

Computes the net new number of shares from potentially dilutive securities, such as options and warrant, to be used in the denominator of the EPS calculation.

Question 107

Quick way to check whether convertible PS is dilutive:

Answer 107

Preferred dividend ÷ # of shares that’ll be created if the PS is converted.

• If this # is < basic EPS, it’s diluted.

Question 108

Quick way to check whether convertible debt is dilutive:

Answer 108

[ Convertible debt interest * (1 - T) ] ÷ convertible debt shares

• If this # is < basic EPS, it’s diluted.

Question 109

True or false: If diluted EPS < basic EPS, the security is dilutive and must be included in the diluted EPS. If no, the security is antidilutive and not included in diluted EPS?

Answer 109

TRUE

Question 110

True or false: Firms must report antidilutive security amounts in the footnotes?

Answer 110

TRUE

Question 111

How to forecast share-based compensation expense and shares outstanding?

Answer 111

First of all, share-based compensation expense is a part of COGS, R&D expense, and SG&A expense in the IS. If we expect the proportions of share-based compensation expense to each of these three items to remain constant, then we do not need to separate share-based compensation expense out. But if it won’t stay constant, then we do have to separate it out. Sources that can help predict change in this expense are historical data, mgmt guidance, and assumptions about reversion to the industry mean. Analysts should also forecast any increase/decrease in anticipated # of shares outstanding. Recall, since share-based compensation expense is not a cash outlay, it should be added back to net income in CFO.

Question 112

Defined contribution plan

Answer 112

A type of retirement pension plan where the firm contributes a sum each period prior to the employee’s retirement account. Listed as pension expense on the IS.

Accounting treatment: No impact on b/s. Pension expense in the IS equals employer’s contributions each period.

• Employee bears the risk because the employer makes no promise regarding the future value of the plan’s assets.

Question 113

Defined benefit plan

Answer 113

A type of retirement pension plan where the firm pays an employee a lump sum or periodic payment each period after the employee retires. Employer bears the risk because the benefit is pre-determined. Typically, firms fund this plan by contributing assets to a pension fund. These assets are then managed to generate the growth necessary to pay the pension benefits as they come due.

Accounting treatment:

Question 114

Funded status of the plan

Answer 114

Difference between the assets in a pension fund and the benefit obligation. If the plan assets > the pension obligation, it’s overfunded. If the plan assets < the pension obligation, it’s underfunded.

Question 115

True or false: other post-employment benefit plans other than the pension, such as healthcare, are funded in an investment fund as well?

Answer 115

FALSE

Question 116

Projected benefit obligation (PBO)

Answer 116

PV of all future pension benefits earned to date based on expected future salary increases.

• Assumes firm is a going concern.
• Discount rate= yield on investment-grade corporate bonds.

Question 117

Funded status

Answer 117

The economic standing of a pension plan. If positive, the pension fund/trust is reported as an asset under IFRS and GAAP. If negative, it’s reported as a liability.

Beginning funded status calculation: funded status = Beginning plan assets - beginning PBO

Ending funded status = FV of plan assets - EOY PBO

Question 118

Closing PBO (EOY PBO) Calculation:

Answer 118

BOY PBO + service costs + interest cost +/- actuarial gains/losses +/- past service costs - benefits paid = Closing PBO

Question 119

Current service cost

Answer 119

An element of PBO. The PV of benefits earned by employees in the current period. This is the change in PBO attributed to employees’ efforts during the year.

Question 120

Past (prior) service costs/ Plan amendments

Answer 120

An element of PBO. When a firm amends its pension plan retroactively (ex: changing the payout from 60% to 65% of final salary), the PBO is immediately increased by the PV of increased benefits already earned.

• Under GAAP, changes in past service costs are amortized in the IS over time.
• Under IFRS, vested past service costs are recognized immediately.

Question 121

Interest cost

Answer 121

An element of PBO. The increase in the PBO resulting from the passage of time.

GAAP Calculation: PBO at start of period * discount rate

PBO at start of period= Beginning PBO + any prior service costs

IFRS Calculation: (beginning funded status - past service cost) * discount rate.
* If resulting amt is negative, an expense is reported. If positive, it’s reported as net interest income.

Question 122

Expected return on plan’s assets

Answer 122

The employer contributes assets to a fund/trust to satisfy future obligations. The expected return on these plans’ assets is used as an offset for the computation of reported pension expense.

• This is NOT reported on the b/s, but instead stated in the disclosures.

Question 123

Actuarial assumptions

Answer 123

an estimate or forecast of an uncertain variable or event

• Changes in actuarial assumptions are reflected in the IS over time under GAAP. Under IFRS, changes in actuarial assumptions are called re-measurements, which are taken to OCI and not amortized.

Question 124

Actuarial gains and losses (GAAP)/ Remeasurements (IFRS)

Answer 124

An element of PBO. There are two components to actuarial gains/losses: the gain/loss due to a decrease/increase in PBO from changes in actuarial assumptions affecting PBO. The second component is the difference between the actual and expected returns on the pension fund’s assets. Both of these components begin in OCI and then under GAAP it’s amortized in the IS.

• Under IFRS, gains/losses are NEVER amortized.
• Under GAAP, gains/losses are amortized using the corridor approach.

Question 125

Corridor approach

Answer 125

Only used for GAAP. For any period, once the beginning balance of actuarial gains/losses > 10% of the greater of the beginning PBO or the plan’s assets, amortization is required. The amortization of an actuarial gain results in a reduction to pension cost, whereas amortizing actuarial loss leads to an increase in pension cost.

Question 126

FV of plan assets at EOY

Answer 126

Fair value of plan assets at BOY +/- actual return on plan assets + employer contributions - benefits paid to retirees.

Question 127

Periodic Pension expense in the IS under GAAP

Answer 127

Net periodic benefit costs + service cost + interest cost - expected return on plan assets +/- amortization of actuarial gains/losses +/- amortization of past service costs

Question 128

Periodic Pension expense in the IS under IFRS

Answer 128

Net periodic benefit costs + service cost +/- net interest expense/income - past service costs

Net interest expense/income = (beginning funded status - past service cost) * discount rate

• Net interest income/expense is the interest expense reported on the IS. This will likely be a different result than interest expense in PBO due to interest income on plan assets.

Question 129

What are firms under IFRS required to disclose related to defined benefit plans

Answer 129

• Disclose the main characteristics of the plan and the risks involved.
• Identify and explain the figures in the financial statements arising from them.
• Describe the amount, timing, and uncertainty of FCFs.

Question 130

What are the considerations of post-employment benefits that need to be made in financial modeling?

Answer 130

Pensions costs are generally a part of SG&A or COGS which are typically shown as a % of revenue. This is normally fine, however, if a plan is set to change, a separate forecast needs to be made. An underfunded liability should be deducted from enterprise value in a financial model.

Question 131

True or false: Minority interest is included in the parent’s company’s equity under the equity method and acquisition method?

Answer 131

False, minority interest is included in the parent’s company’s equity under the acquistion method only.

Question 132

True or false: GAAP pension accounting standards require public companies to report expected returns on the plan’s b/s?

Answer 132

False, expected returns on the plan are stated in the disclosures. Funded status is required to be stated on the b/s.

Question 133

True or false: GAAP standards are consistent with IFRS standards for pension plans?

Answer 133

False, they are consistent on the b/s but NOT on the IS.

Question 134

What is the primary goal of financial statement analysis?

Answer 134

To facilitate economic decisions

Question 135

True or false: depreciation expense increases as the depreciable life of an asset decreases?

Answer 135

TRUE

Question 136

True or false: Under accrual accounting, revenue should be recognized when the order is confirmed?

Answer 136

False, revenue should be recognized when earned and payment is assured.

Question 137

True or false: Quality of financial reports is assessed by answering two questions: Whether the financial reports are decision useful and GAAP compliant and whether the results quality is high (i.e., earnings provide adequate return on capital and are sustainable)?

Answer 137

TRUE

Question 138

True or false: Stock appreciation rights do not cause dilution to the existing shareholders since no shares are actually issued?

Answer 138

TRUE

Question 139

True or false: Companies with large proportions of accruals-based earnings historically have experienced slower reversions to the mean compared to companies with large cash-based earnings?

Answer 139

FALSE

Question 140

True or false: Non-discretionary accruals are more likely to indicate manipulation than discretionary?

Answer 140

FALSE

Question 141

True or false: Under the current rate and temporal method, dividends are translated at the exchange rate that existed on the dividend declaration date?

Answer 141

TRUE

Question 142

True or false: During growth, operating cash flow is usually higher than operating income as the firm uses cash to increase inventories and receivables?

Answer 142

False, during growth, operating cash flow is usually lower than operating income as the firm uses cash to increase inventories and receivables.

Question 143

How does aggressive revenue recognition affect the financial statements?

Answer 143

Aggressive revenue recognition practices would increase accounts receivable, revenues, expenses, income and stockholder’s equity. Ending inventory would decline but by less than the increase in accounts receivable resulting in increase in total assets. Early recognition of revenues also accelerates recognition of expenses (COGS).

Question 144

True or false: The IS is a true measure of economic pension expense?

Answer 144

False, the IS + OCI is a true measure of economic pension expense. There is smoothing in the IS due to prior service costs or actuarial gains/losses.

Question 145

What is reported on the b/s related to pension accounting?

Answer 145

Funded status. The funded status is the difference in the PBO and the plan assets. If the PBO exceeds the plan assets, the difference is reported as a liability. If the plan assets exceed the PBO, the difference is reported as an asset. If the amounts are the same, then neither a liability nor asset needs to be reported.

Question 146

True or false: Pension costs included in the cost of production (ex: labor costs included in the value of work-in-process or finished goods) must be expensed?

Answer 146

False, pension costs included in the cost of production may be capitaized as part of valuation of ending inventory. When this inventory is eventually sold, such costs are expensed as a component of cost of goods sold.

Question 147

True or false: The expected rate of return affects PBO?

Answer 147

False, expected return relates to the pension expense, not to the size of the obligation.

Question 148

True or false: The fair value of plan assets is increased by the amount of the expected return on assets?

Answer 148

False, the MV of plan assets is increased by the ACTUAL return on assets.

Question 149

True or false: Share-based compensation reduces shareholders equity but leverage is unchanged?

Answer 149

False, share-based compensation does not affect shareholders equity nor leverage. Compensation expense reduces net income (and retained earnings) but would increase compensation expense reserve – leading to no net change in equity.

Question 150

True or false: The compensation expense is amortized over the vesting period in the income statement?

Answer 150

True, compensation expense is based on the MV of the options on the grant date. The compensation expense is then allocated straight line in the IS over the vesting period, which is the time between the grant date and the vesting date.

Question 151

What aspects of employer benefit plans must be recognized in CFO?

Answer 151

Employer contributions

Benefits paid is not recognized in CFO

Question 152

True or false: D/E is higher under full goodwill than partial goodwill?

Answer 152

False, D/E is lower under full goodwill than partial goodwill. Since purchase price > prorate share of FVNA, goodwill is positive. Full goodwill > partial goodwill and minority interest under full goodwill will be higher than minority interest under partial goodwill. Because minority interest is part of equity, equity will be higher under full goodwill and debt-to-equity ratio will be lower. Net income would be the same and hence ROE under full goodwill will be lower.

Question 153

True or false: when receivables are securitized, the sponsor reports the cash inflow as CFI?

Answer 153

False, when the receivables are securitized, the sponsor removes the receivables from the balance sheet and reports the cash inflow as an operating activity in the cash flow statement

Question 154

True or false: Fair value is only estimated on the grant date; subsequent changes in fair value are not considered?

Answer 154

True

Question 155

Approaches for forecasting the dilution from future grants of share-based compensation and its effects on valuation

Answer 155

1. Discounting the estimated value of equity by a dilution factor (this entails adding an estimated # of shares outstanding to account for future grants)
2. Deduct share-based compensation expense from estimates of free cash flows and not worry about forecasting dilutive shares.