CFA L2 FSA (Part 2/2) Flashcards
Two ways foreign currency can affect a multinational firm’s financial statements:
- The firm may engage in business transactions that are denominated in another currency.
- The firm may invest in subsidiaries that maintain their books and records in a foreign currency. In both cases, special accounting treatment is required.
Local currency
The currency where the foreign subsidiary is located.
Functional currency
The currency of the primary economic environment where the firm operates.
- This is the currency where the firm spends its cash.
- The functional currency may or may not be the local currency.
Presenting currency/reporting currency
The currency that the parent company presents its financial statements.
Three risks in multinational operations:
Translation risk= Tends to affect bigger, multinational firms. This is the risk where the subsidiary must convert their currency into the parent’s currency at the date of consolidation and it’ll cause a loss.
Transaction risk= The risk that the exchange rate can move between entering a FX contract and settling the contract.
Economic risk= The risk that movements in exchange rates will affect imports/exports.
True or false: Foreign currency risk occurs when the transaction date and payment date are the same?
False, when they differ.
Ex: A US firm sells goods to a firm located in Italy for $10,000 when the spot exchange rate is $1.60 per Euro. The payment is due in 30 days and when the payment is actually received the exchange rate is now $1.50. On the transaction date, the US recognizes a sale of ($10,000 * $1.60) = $16,000. On the payment date, the US firm receives ($10,000 * $1.50)= $15,000 … so the US firm must record a $1,000 loss in the IS and thus a $1,000 decrease in RE.
Transaction exposure example when the settlement date is after the b/s date:
Ex: A US firm sells goods to a firm located in Italy for $10,000 when the spot exchange rate is $1.60 per Euro on Dec. 15. The payment is due in 30 days on Jan. 15 and when the payment is actually received the exchange rate is now $1.50. Obviously, the settlement date is in the next accounting period. At Dec. 31, the exchange rate was $1.56.
On the transaction date, Dec. 15, the US recognizes a sale of ($10,000 * $1.60) = $16,000. The B/S reflects a $16,000 increase to assets. At Dec. 31, The US recognizes a loss of $10,000 * ($1.56 - $1.60) = $400 to the IS and thus a $400 decrease to RE. The B/S reflects the $400 reduction to assets. At Jan. 15, The US recognizes another loss of $10,000 * ($1.50 - $1.56) = $600 to the IS and thus a $600 decrease to RE. The B/S reflects the $600 reduction to assets.
True or False: IFRS and GAAP provide guidance to where transaction gains/losses should be recognized in the IS?
False, IFRS and GAAP both say that transaction gains/losses must be reported in the IS but not where within the IS.
Process of translation of foreign currency of financial statements.
- Identify the subsidiary’s local currency.
- Convert the local currency balances into the functional currency.
- Convert the functional currency balances into the parent’s reporting currency using closing rates.
- Some of these may be the same but it is possible that all 3 are different.
Remeasurement/ Temporal method/ nonmonetary method
Converting the local currency into functional currency.
- Use the temporal method when the functional current is the same as the parent’s presentation currency.
- Subsidiaries reporting their results in the local currency that is NOT the functional currency use the temporal method.
Translation/ Current rate/all-current method
Converting the functional currency into the parent’s presentation/reporting currency.
- Use the current rate method when the functional currency and the parent’s presentation currency differ.
- Self-contained, independent subsidiaries reporting their results in the local currency that is also the functional currency use the current method.
IASB guidance on which currency should be the functional currency:
The currency that influences sale prices of goods/services. Currency of the country whose competitive forces and regulations determine the sale prices of goods/services. The currency that influences labor, material, & other costs. The currency from which funds are generated. The currency in which receipts from operating activities are usually retained.
True or false: In a case where the local currency, functional currency, and presentation/reporting currency all differ, both the temporal method and current rate method are used?
TRUE
In a situation with hyperinflation, how do we account for translation of currencies?
Under GAAP, the functional currency is considered to be the parent’s presentation currency and the temporal method is used.
Under IFRS, the subsidiary’s financial statements are restated for inflation and then translated using the current exchange rate.
Current rate vs average rate vs historical rate
Current rate/Closing exchange rate= The exchange rate on the b/s date
Average rate= The average exchange rate over the reporting period
Historical rate/actual rate= The actual rate that was in effect when the original transaction occurred.
Applying the Temporal Method
On the b/s, monetary assets & liabilities are restated using the current exchange rate. All other assets are considered to be non-monetary and are restated at the historical exchange rate. Any nonmonetary assets or liability measured on the b/s at FV is restated at the current exchange rate. Capital stock is restated at the historical exchange rate. On the IS, common stock and dividends paid are restated at the historical exchange rate. Expenses related to nonmonetary assets (ex: COGS, D&A) are restated at the historical exchange rate. Revenues and all other expenses are translated at the average rate. Any remeasurement gain/loss is recognized in the IS. This leads to a more volatile NI compared to the current rate method because there the translation gain/loss is reported in equity.
Monetary assets & liabilities
Assets & liabilities that are fixed in the amount of currency to be received or paid.
Ex: Cash, receivables, payables, short-term debt, and long-term debt.
Ex of nonmonetary assets & liabilities: inventory, fixed assets, intangible assets, deferred revenue.
True or false: Inventory valuation methodologies (LIFO, FIFO, etc.) play a major role in the temporal method?
True, when restating items using the historical method, FIFO and LIFO can play a large role. For example, FIFO COGS consists of costs that are older, thus the exchange rates used to remeasure COGS are older compared to LIFO.
Applying the Current Rate Method
Start w/ the IS with this method. On the IS, all accounts are translated at the average rate. Dividends are also translated at the historical exchange rate. Any translation gain/loss is reported in shareholders’ equity as part of the cumulative translation adjustment (CTA). CTA is a part of OCI. When CTA is disposed, it passes through the IS. On the b/s, all accounts are translated at the current rate except for common stock which is translated at the historical exchange rate.
- Taxes are reported at the average rate under both the current rate method and the temporal method.
How to calculate ending RE:
Beginning RE + NI - dividends paid
Example of how to calculate CTA under the Current Rate Method given:
Assets= $1,000
Liabilities= $600
Common Stock= $150
Beginning RE= $175
Current NI= $50
Dividends paid= $25
First, we need to calculate ending RE= $175 + $50 - $25 = $200
Now we can back into CTA: $1,000 (assets) - $600 (liabilities) = $400.
Given that ending RE= $200 and CS = $150, we know that $400 - $200 - $150 = $50.
True or false: Under the temporal method, all of the parent company’s assets are exposed to changing rates?
False, only the net monetary assets = (monetary assets - monetary liabilities) position is exposed to changing rates. If a firm is balanced, meaning monetary assets = monetary liabilities, there is no exposure under the temporal method.
COGS calculation
Beginning inventory + purchases - ending inventory
True or false: pure b/s ratios and pure IS ratios are affected by the temporal method and current rate method?
False, they are unaffected.
Pure means that all of the components of the pure b/s ratio are from the b/s or all of the components from the pure IS ratio are from the IS.
Mixed ratio
A ratio the combines inputs from the IS and b/s.
- These ratios are affected by the temporal and current rate methods. Ex: ROA
True or false: If accounts receivable turnover increases, receivables collection period will decrease?
True
Accounts receivable turnover= net sales ÷ accounts receivable.
True or false: If the foreign currency is depreciating, translated mixed ratios (with an IS item in the numerator and an EOP item in the denominator) will be smaller than the original ratio?
False, if the foreign currency is depreciating, translated mixed ratios (with an IS item in the numerator and an EOP item in the denominator) will be larger than the original ratio.
True or false: If the foreign currency is appreciating, translated mixed ratios (with an IS item in the numerator and an EOP item in the denominator) will be larger than the original ratio?
False, if the foreign currency is appreciating, translated mixed ratios (with an IS item in the numerator and an EOP item in the denominator) will be smaller than the original ratio.
How to compare impact of the current rate method vs the temporal method on ratios?
- Determine if the local currency is appreciating or depreciating.
- Determine which rate (historical, current, or average) is used to convert the numerator under both methods.
- Determine whether the numerator will be smaller, the same, or larger under the temporal or current rate method.
- Determine which rate (historical, current, or average) is used to convert the denominator under both methods.
- Determine whether the denominator will be smaller, the same, or larger under the temporal or current rate method.
- Determine whether the ratio will increase, decrease, or stay the same based on the direction of the change in the numerator and denominator.
True or false: In a hyper-inflationary environment, a local currency will rapidly appreciate against the presentation currency?
False, depreciate
Hyperinflation
3 year cumulative inflationary environment w/ an inflation rate > 100% (GAAP). In a hyper-inflationary environment, the current rate will result in significantly lower assets/liabilities of the subsidiary.
- Nonmonetary assets/liabilities are not affected by hyperinflation.
- Under IFRS, firms can adjust for inflation but under GAAP they cannot. The temporal method is used under GAAP in a hyperinflationary environment.
How to adjust for hyperinflation under IFRS:
Nonmonetary assets & liabilities are restated for inflation using a price index. Since most nonmonetary items are reported at historical cost, simply multiply the by the quotient of the price index for the b/s date divided by the acquisition date. Monetary assets/liabilities are generally not restated. The components of equity (other than RE) are restated by applying the change in the price index from the beginning of the period. Simply multiply the by the quotient of the price index for the b/s date divided by the acquisition date. RE will be used as a plug figure. The income statement items are restated by multiplying by the quotient of the price index for the b/s date divided by the average rate (assuming that purchases were made evenly throughout the year). The net purchasing power gain or loss is recognized in the IS based on the net monetary asset/liability exposure. This is mostly a plug figure to ensure that revenues - expenses = NI.
Similarities between the temporal method and current method when adjusting for inflation:
Under the temporal method, monetary assets/liabilities are exposed to exchange rate risk, whereas under the current rate method they are exposed to inflation risk. Purchasing power gains/losses are the same concept as exchange rate gains/losses when the foreign currency is depreciating. Any gain/loss from remeasurement is recognized in the IS just like net purchasing power gains/losses are recognized in the IS.
True or false: In a hyperinflationary environment, under IFRS, monetary assets will result in purchasing power gains and monetary liabilities will result in purchasing power losses?
False, in a hyperinflationary environment, under IFRS, monetary assets will result in purchasing power losses and monetary liabilities will result in purchasing power gains?
Effective tax rate
The percent of income that an individual or corporation owes/pays in taxes. A disclosure must be made that reconciles the difference between the effective tax rate and the statutory tax rate.
Calculation: Tax expense ÷ pretax profit
- Statutory and effective tax rates will differ if a firm has overseas subsidiaries.
Statutory tax rate
The tax code of the home country.
- Changes in the effective tax rate on account of foreign operations can be due to changes in the mix of profits from different countries w/ varying tax rates and changes in tax rates.
True or false: When evaluating a company’s sales, most of the time we want to strip out a company’s exchange rate gains/losses?
True, we want to see organic growth in sales not the effects of currencies. Currency effects distort sales growth.
True or false: Analysts can use disclosures to evaluate the impact of changes in currency values on a company’s business?
TRUE
3 ways financial institutions differ from regular companies:
- Systemic importance
- More heavily regulated.
- Types of assets
True or false: Global regulatory bodies coordinate to determine rules for oversight of banks and to prevent regulatory arbitrage?
TRUE
Basel Committee on Banking Supervision
A committee under the Bank of International Settlements that develops a worldwide regulatory framework for banks. The current framework is called Basel III.
3 pillars of Basel III’s framework:
- Minimum capital levels: the riskier the bank’s assets, the more required capital.
- Liquidity: Banks must hold enough liquid assets for a 30-day stressed scenario.
- Stable funding
Primary other global organizations that coordinate bank regulations:
- Financial stability board
- International Association of Deposit Insurers: Seek to improve effectiveness of deposit insurers.
- IOSCO: Maintains fair and efficient security markets.
- International Association of Insurance Supervisors (IAIS): Regulates the insurance industry.
True or false: The FDIC alone determines how risk weightings are applied to bank assets?
False, risk-weighting is specified by the individual regulators.
Tier 1 Capital
Tier 1 capital is a bank’s primary form of capital. Tier 1 capital is made up of: CE Tier 1 Capital: common stock, additional paid-in capital, RE, and OCI minus intangibles and DTA.
Other Tier 1 Capital: Subordinated instruments w/ no specified maturity and no contractual dividends (ex: PS w/ discretionary dividends)
Total capital = Tier 1 capital + Tier 2 capital
Basel III guidelines regarding CE tier 1 capital, tier 1 Capital, and total capital as a % of risk weighted assets:
CE tier 1 capital must = 4.5% of RWA
Tier 1 capital must = 6% of RWA
Total capital must = 8% of RWA
- Individual regulators can make these restrictions tighter.
Asset quality
The process of generating assets, managing them, and controlling overall risk. Analysis of AQ involves measuring credit risk. Loans are the main asset and generally carried at amortized cost net of allowances.
Reverse repurchase agreements
Bank loans advanced under a repurchase agreement.
- Reverse repo is when a firm sells an asset with an obligation to buy them back later at a higher price.
Assets held for sale
Bank assets that the b/s assumes disposition. These are classified as discontinued operations.
Allowance for loan losses
A contra account that is a provision for loan losses. This is an expense subject to mgmt discretion. When an actual loss occurs (assuming no recovery), these are written off against the ALLL.
What are the 3 ratios used to evaluate ALLL:
- ALLL: non-performing loans
- ALLL: net loan charge-offs
- Provision for loan losses: net loan charge-offs
- Provision for loan losses: net loan charge-offs
How to value the FV of banks assets?
We use the FV hierarchy based on types of inputs used in determining FV:
Level 1 inputs are the market price of identical assets.
Level 2 inputs are observable but not market prices of identical assets. We look at similar assets or interest rate spreads or implied volatility.
Level 3 inputs are non-observative and therefore objective (Ex: DCF)
What are high quality earnings?
return on equity > cost of capital. We want earnings to be sustainable, on a positive trend, unbiased estimates, and come from recurring sources.
Primary sources of earnings for a bank
- Net interest income
- Service income:
- Trading income: most volatile year-to-year
- Higher #1 and #2 will lead to more sustainable earnings.
Minimum liquidity ratios under Basel III
Liquidity coverage ratio (LCR)
Calculation: highly liquid assets ÷ expected cash outflows
* Expected cash outflows are estimated one-month cash requirements in a stressed scenario.
* Banks need a minimum LCR of 100%
Net stable funding ratio (NSFR)
Calculation: Available stable funding (ASF) ÷ required stable funding
* Banks need a minimum NSFR of 100%.
* Available stable funding is the composition and maturity distribution of a bank’s funding sources.
* Required stable funding is the composition and maturity distribution of a bank’s assets.
Interest rate risk
The result of differences in maturity, rates, and repricing frequency between the bank’s assets and its liabilities.
Besides CAMELS, what other factors should analysts consider when analyzing a bank?
- Government support: (ex: deposit insurance).
- Government ownership: government ownership increases public faith in the banking system.
- The bank’s mission: community banks are more likely to have asset concentrations.
- Culture: (ex: risk averse vs risk taking). Too risk averse means insufficient returns, whereas too much risk can lead to failure.
- The competitive environment the bank is in.
- Off b/s items (ex: derivatives, LOCs, etc.)
- Currency exposure
How to evaluate culture of banks
- Are losses stemming from narrow-focused investment strategies or too much risk?
- Are there internal control issues?
- Is mgmt’s compensation excessively tied to stock price performance?
- How quickly does the bank adjust loan loss provisions to actual loss behavior?
Types of insurance companies
- Property and casualty (P&C)
- Life and health (L&H)
Types of revenues for insurance companies
- Income on premiums
- Income on float= Premiums not paid out in claims
Property & Causality (P&C) insurers
Property insurance deals w/ properties and causality insurance (a.k.a liability insurance) protects against a legal liability. Main source of income is premiums. To be profitable, P&C insurers need to have good underwriting, charge enough premiums for the risk, and diversify their risk (by selling policies to many customers and selling different types of insurance). Typically, P&C policies are short-term and renegotiated frequently. The main expenses for P&C firms are claims and the cost of writing new policies. These firms also make money off of investing premiums. P&C margins are cyclical. During a soft pricing period- a period of losses and shrinking capital bases due to increased competition, more P&C firms will leave the industry. This will lead to higher profits (hard pricing period), and then more firms will enter.
Direct writers vs agency writers
Direct writers are insurance firms w/ their own sales and marketing staff. Higher fixed costs.
Agency writers are insurance firms that use insurance agents. Higher variable costs due to commissions paid to the agent.
Multiple peril policy
A policy that covers property insurance and liability insurance.
Underwriting loss ratio/loss and loss adjustment expense
A profitability ratio for insurers. Measures the relative efficiency of the firm’s underwriting standards- whether the policies are priced appropriately relative to risks.
Calculation: (Claims paid + $ in loss reserves) ÷ net premium earned
* Lower is better
