Financial accounting

Question 1

Module 9.1, LOS 9a, 9b

A) Investments in marketable debt and equity securities can be categorized as:
B) What is the main distinction between them?

Answer 1

A)

1. investments in financial assets
2. investments in associates
3. joint ventures
4. business combinations

B) The degree of influence or control (rather than purely on the percent holding)

Question 2

Module 9.1, LOS 9a, 9b

Name relative ranges for degrees of influence and their possible accounting treatments

Answer 2

1. lack of influence <20% - financial assets - FVPL, FVOCI, Amortized cost
2. significant influence 20%<=share<=50% - associates - equity method
3. control >50% - business combinations - consolidation method

Question 3

Module 9.2, LOS 9a, 9b

Name major changes of IFRS9 compared to IAS39 regarding financial assets measurement and classification

Answer 3

1. Business model approach, three classifications: FVPL, FVOCI, Amortized cost
2. Reclassifications of debt instruments permited between FV to amortized only when the business model changes (and forbiden between FVOCI and FVPL)
3. Equity reclassification is not permited
4. Provisioning model switch from “incurred loss” to “expected loss” (12month - performing, lifetime - non-performing)

Question 4

Module 9.2, LOS 9a, 9b

What are the criterias to recognise financial assets at amortized cost?

Answer 4

1. The business objective for financial assets is to collect contractual cash flows
2. The contractual cash flows are solely for principal and interest on principal
3. Financial asstets are not ment to be sold

Question 5

Module 9.2, LOS 9a, 9b

Can an entity deside to use FVPL for ‘held-to-collect and sell’ instruments and why?

Answer 5

It can (instead of FVOCI) to eliminate accounting mismatch in treatment of assets and liabilities

Question 6

Module 9.3, LOS 9a, 9b

How initial investments in associates are recognized under equity method?

Answer 6

1) Recorded at cost and reported on the balance sheet as a noncurrent asset (most common)
2) Recorded at FV. Allowed under GAAP for all investments, under IFRS for venture capital firms, mutual funds, and similar entities

Question 7

Module 9.3, LOS 9a, 9b

How investee’s income/loss and dividends are recognized for investor under equity method?

Answer 7

W/o FV method
Income - proportionately to holding share, +Inc.st, +Investments account, if losses exceed income => stop using equity method
Dividends - -Investments account, +cash, not recognized in PnL
With FV method
All changes (incl. dividend) recognized in PnL

Question 8

Module 9.3, LOS 9a, 9b
Can you change decision to recognise investment in associate at FV:
1) under GAAP?
2) under IFRS?

Answer 8

No, for IFRS and GAAP this decision cannot be changed

Question 9

Module 9.3, LOS 9a, 9b
For investments in associates, how the excess of purchase price over proportionate book value of investee is recognised for investor? What is goodwill?

Answer 9

At acquisition - allocated to investee’s identifiable A and L based on their FV vs BV, and ownership share. Remainder is goodwill

Subsquent periods - recognized expense based on the excess amt assigned to A and L of investee (consistent with investee’s recognotion of expense methods).

Question 10

Module 9.3, LOS 9a, 9b

Which parts does equity income of investee (investment in associate) contain when recognized for investor?

Answer 10

1) Proportionate income of investee

2) Expense from excess of purchase price over BV of investee attributed to identifiable A and L of investee.

Question 11

Module 9.4, LOS 9a, 9b
Under equity method, how investment in associate will be treated when tested for impairment in:

1) IFRS?
2) GAAP?

Answer 11

IFRS and GAAP

1) if impairment recognised, assets (investement) is written down to FV (or in IFRS through allowance account), loss is incurred in PnL
2) Write-ups are forbidden

GAAP impaired if FV < BV and this is considered parmanent
IFRS impaired if FV < BV and several cases of losses incurred happened, which are beleived to impact business

Question 12

Module 9.4, LOS 9a, 9b

Under equity method, how should investor recognise profit from internal transactions with investee?

Answer 12

Unconfirmed profits from internal deals are not reflected in PnL. Confirmation through deals with external parties

Question 13

Module 9.4, LOS 9a, 9b

Under investment in associates, how revenues, expenses, NI, margins and leverage is different from full consolidation?

Answer 13

1) Revenue: equity m. < consolidation m.
2) Expense abs.: equity m. < consolidation m.
3) NI: equity m. = consolidation m.
4) Margins: equity m. > consolidation m. (revenue of investee in denominator is ignored)
5) Leverage: equity m. < consolidation m. (investees debt ignored)

Question 14

Module 9.5, LOS 9a, 9b

Which methods of business combinations exist (IFRS, GAAP)? What is the difference between them?

Answer 14

IFRS - no distinction
GAAP:
1) Merger - acquiring firm absorbs all the A and L of the acquired firm, which ceases to exist (A+B = A)
2) Acquisition - both entities continue to exist in a parent-subsidiary relationship. Parent reports noncontrolling interest (A+B = (A+B))
3) Consolidation - a new entity is formed that absorbs both of the combining companies. (A+B = C)

Question 15

Module 9.5, LOS 9a, 9b

Which accounting methods were historically used for business combinations? Which ones are left?

Answer 15

1) Purchase method -> now acquisition method

2) Pooling-of-interest method -> removed from IFRS and GAAP

Question 16

Module 9.5, LOS 9a, 9b

Describe key features of pooling-of-interests method for business combinations?

Answer 16

1) The two firms are combined using historical BV
2) Operating results for prior periods are restated as though the two firms were always combined
3) Ownership interests continue, and former accounting bases are maintained
4) FV played no role (price paid eliminated)

Question 17

Module 9.7, LOS 9a, 9b

Under acquisition method, what is goodwill?

Answer 17

1) GAAP and IFRS: full goodwill = (fair value of equity of whole subsidiary) − (fair value of net identifiable assets of the subsidiary)
2) IFRS only: partial goodwill = purchase price − (% owned × FV of net identifiable assets of the subsidiary)
or partial goodwill = % owned × full goodwill

Question 18

Module 9.7, LOS 9a, 9b
Under acquisition method:
1) which method gives higher goodwill: full goodwill or partial?
2) how minority interest is calculated under full and partial method?
3) which method gives higher Assets, Equity, minority interest, ROA, ROE?

Answer 18

1) Partial goodwill = % owned × full goodwill => partial is lower
2) full method - minority % of acquired company FV,
partial method - minority % of acquired company net identifiable assets FV
3) Assets, Equity, minority interest is higher under full goodwill, ROA, ROE - under partial

Question 19

Module 9.7, LOS 9a, 9b

How in IFRS and GAAP under full consolidation goodwill is tested for impairment

Answer 19

1) IFRS - 1 step - carrying amount of the cash generating unit > recoverable amount => impairment loss
2) GAAP - 2 steps - 1. carrying value of the reporting unit (incl. goodwill) > FV of the reporting unit => impairment exists. 2. loss = carrying value of the goodwill - implied FV of the goodwill

In PnL - impairment loss is a part of continuing operations.

Question 20

Module 9.7, LOS 9a, 9b
How in IFRS and GAAP under full consolidation ‘negative goodwill’ or ‘bargain purchase’ (when price paid < FV of net assets) should be recognised?

Answer 20

IFRS and GAAP - gain in the income statement

Question 21

Module 9.8, LOS 9a, 9b

Which accounting methods are used for joint ventures?

Answer 21

1) Equity method (most common)

2) Proportionate consolidation (allowed in rare cases)

Question 22

Module 9.8, LOS 9a, 9b

How proportionate consolidation is different from full consolidation?

Answer 22

All BS and PnL items are reported in proportion of ownership => minority interest is not required.
Equity of acquired firm is ignored

Question 23

Module 9.9, LOS 9a, 9b

Name key features of SPE

Answer 23

1) No sufficient amount at risk for the entity to finance its activities without additional subordinated financial support
2) Investors lack controlling financial interest
3) Created to reduce risk and thereby lower the cost of financing

Under GAAP if 1 or 2 present, SPE is VIE

Question 24

Module 9.9, LOS 9a, 9b

What is the accounting treatment for SPE?

Answer 24

1) Under IFRS consolidation is required
2) Under GAAP 2-part consoliodation is required (VIE):
1 - variable interest component: primary beneficiary consolidates VIE regarless of voting interest
2 - voting interest (control) component

Question 25

Module 9.9, LOS 9a, 9b
How contingent assets and liabilities are recognized in acquisition in:
1) IFRS?
2) GAAP?

Answer 25

1) IFRS- A - never recognized, L - at FV on acquisiton date, only if FV can be measured reliably
Subsequent periods - L - max( initial FV, best estimate of the future settlement amount)

2) GAAP - contractual + probable non-contractual A, L - at FV on acquisition date
Subsequent periods - L - max( initial FV, best estimate of the future settlement amount), A - min( initial FV, best estimate of the future settlement amount)

Question 26

Module 9.9, LOS 9a, 9b
How contingent consideration (indemnifications) is recognized in acquisition in:
1) IFRS?
2) GAAP?

Answer 26

In IFRS and GAAP:
At FV as A, L or E.
Subsequent periods: if A or L - changes in PnL, if У - changes in E.

Question 27

Module 9.9, LOS 9a, 9b
How in-process R&D is recognized in acquisition in:
1) IFRS?
2) GAAP?

Answer 27

In IFRS and GAAP:
Recognised as asset, capitalized as an intangible asset
Subsequent period: successfull - amortized, unsuccessfull - impaired

Question 28

Module 9.9, LOS 9a, 9b
How restructuring costs are recognized in acquisition in:
1) IFRS?
2) GAAP?

Answer 28

In IFRS and GAAP:

Expensed when incurred and not capitalized as part of the acquisition cost

Question 29

Module 9.9, LOS 9c
Compare E, A, L, minority interest, NI, revenues and expenses, ROA, ROE and margins under equity method, proportionate consolidation and acquisition

Answer 29

1) A, L, revenues, expenses: equity method < proportionate consolidation < acquisition
2) E: (equity method = proportionate consolidation) < acquisition
3) minority interest: only under acquisition
4) NI: equity method = proportionate consolidation = acquisition
5) margins, ROA: acquisition < proportionate consolidation < equity method
6) ROE: acquisition < (proportionate consolidation = equity method)

Question 30

Module 10.1, LOS 10a

What are the types of pension plans? What are the key differencies?

Answer 30

1) Defined contribution plan
- expense is equal to the employer’s contribution
- no future obligation to report on the BS
- investment risk is on employee
2) Defined-benefit plan
- firm promises to make periodic payments to the employee after retirement. Total periodic pension cost = firm’s contributions - the change in funded status
- future obligation exists on BS
- investment risk is on employer

Question 31

Module 10.1, LOS 10a, 10.2, LOS 10b
What is funded status of the pension plan? How is it recognised in:

1) IFRS?
2) GAAP?

Answer 31

Funded status of the plan - Plan Assets - PBO
If funding oblig. > fund assets => underfunded
If funding oblig. < fund assets => overfunded

In both, IFRS and GAAP:
balance sheet liability = negative funded status
balance sheet assets = min (positive finded status; ceiling of PV of future economic benefits (s.a. future refunds or reduced contributions).

Question 32

Module 10.1, LOS 10a

What is the difference between defined-benefit pension plan and other post-employment benefits?

Answer 32

Difference is in funding:

1) defined-benefit pension plan are usually funded
2) other post-employment benefits are usually unfunded

For other post-employment benefits expence is recognised as benefits are earned, Cfs are uneffected until paid to employee

Question 33

Module 10.2, LOS 10b

What is annual unit credit?

Answer 33

Annual Unit Credit (benefit) = PV of annuity at retirement ÷ number of years of service

Question 34

Module 10.2, LOS 10b

What are the main components of PBO changes?

Answer 34

BPBO
1) + Current service cost - PV of benefits earned for +1 year of working
2) + Interest cost = DR*(BPBO+past service cost)
3) + Past (prior) service costs - retroactive benefits awarded to employees when a plan is initiated or amended
4) + Actuarial losses/gains due to changes in actuarial assumptions (mortality, employee turnover, retirement age, and the discount rate)
5) - Benefits paid
EPBO

Question 35

Module 10.2, LOS 10b

What are the main components of plan Assets changes?

Answer 35

BPA
1) + Contributions
2) + Actual returns
3) - Benefits paid
EPA

Question 36

Module 10.3, LOS 10c

What is total periodic pension cost (TPPC)?

Answer 36

TPPC - economical cost of the pension plan to company
TPPC = employers contributions - (ending funded status - beginning funded status)
Cost is either paid (via contributions), either deferred (via funded status worsening)
From accounting perspective:
TTPC = periodic pension cost in P&L + periodic pension cost in OCI

Question 37

Module 10.3, LOS 10c
Which periodic pension cost is reported in IFRS in:

1) PnL?
2) OCI?

Answer 37

1) PnL:
- Current service cost
- Interest cost at DR
- Expected return on assets at DR
- Past service cost

2) OCI:
- Actuarial gains/losses part 1 (changes in diff. between expected and actual returns) - unamortized, ‘‘remeasurements’’
- Actuarial gains/losses part 2 (changes in actuarial assumptions) - unamortized, ‘‘remeasurements’’

Question 38

Module 10.3, LOS 10c
Which periodic pension cost is reported in GAAP in:

1) PnL?
2) OCI?

Answer 38

1) PnL:
- Current service cost
- Interest cost at DR1
- Expected return on assets at DR2
- Actuarial gains/losses part 1 (changes in diff. between expected and actual returns) - amortized part
- Actuarial gains/losses part 2 (changes in actuarial assumptions) - amortized part
- Past service cost - amortized part (over the service life)

2) OCI:
- Actuarial gains/losses part 1 (changes in diff. between expected and actual returns) - unamortized part
- Actuarial gains/losses part 2 (changes in actuarial assumptions) - unamortized part
- Past service cost - unamortized part

Question 39

Module 10.3, LOS 10c

What is the difference in TPPC and periodic pension cost when accounting returns on assets?

Answer 39

TPPC takes actual returnes, while periodic costs take expected returns. Changes of difference between actual and expected returns are a part of actuarial gains/losses

Question 40

Module 10.3, LOS 10c

What is the difference between expected returns on assets reporting under GAAP and IFRS?

Answer 40

In IFRS DR for expected returns is the same as for interest cost, while in GAAP there is no such assumption

Question 41

Module 10.3, LOS 10c

In GAAP what is the rule for accounting actuarial gains/losses in PnL or OCI?

Answer 41

Actuarial gains/losses are split into 2 parts based on ‘coridor approach’ (materiality threshold)

1) part where abs(actuarial gains/losses) > 10%* max(BPBO; plan assets) - amortized in PnL over the remaining service life (or can be chosen faster)
2) part where abs(actuarial gains/losses) <= 10%* max(BPBO; plan assets) - unamortized in OCI

Question 42

Module 10.4, LOS 10c
How periodic pension cost is presented in:
1) IFRS?
2) GAAP?

Answer 42

IFRS- may be presented in separate lines of inc. st.
GAAP - onу line in income statement
GAAP and IFRS - TPPC disclosed in notes to fin. st.

Question 43

Module 10.4, LOS 10c

In which cases pension costs can be capitalized? What is the tretment in this case?

Answer 43

Pension costs included in the cost of production of goods (e.g., labor costs included in the value of work-in-process or finished goods) may be capitalized as part of valuation of ending inventory. When this inventory is sold, such costs are expensed as a component of COGS.

Question 44

Module 10.5, LOS 10d

Describe main defined benefit pension plan assumptions and their effects on PBO, TPPC, Periodic pension cost in P&L.

Answer 44

1) + discount rate (based on rates of high quality fixed income investments with a maturity profile similar to the future obligation)
- PBO
- TPPC
- interest cost for nonmature plan
- Periodic pension cost in P&L
2) - rate of compensation growth
- PBO
- TPPC
- Periodic pension cost in P&L
3) +expected return on plan assets
- Periodic pension cost in P&L

Question 45

Module 10.5, LOS 10d

When choosing defined benefit pension plan assumptions what should analysist look for first of all?

Answer 45

That all assumptions are based consistently on same macro assumptions (inflation rate, etc.)

Question 46

Module 10.7 LOS 10h

What forms of share-based compensations exists, what is the difference?

Answer 46

1) Stock options - compensation expense based on FV of options on the grant date based on the # of options that are expected to vest.
- equity dilution
2) Stock grants (outright transfer, restricted stock, and performance stock) - compensation expense based on FV of the stock on the grant date.
- equity dilution
3) Stock appreciation rights
- the right to receive compensation based on the increase in P of the firm’s stock over a predetermined amount
- no downside risk
- no equity dilution
- requires cash payment
4) Phantom stock
- similar to stock appreciation rights
- payoff is based on the performance of hypothetical stock instead of the firm’s actual shares
- used in privately held firms and firms with highly illiquid stock

Question 47

Module 10.7 LOS 10h

How stock options are accounted?

Answer 47

• compensation expense is allocated in the income statement over the service period (time berween grant date and vest date)
• NI
  -RE
  +paid-in-capital -> no changes in equity

Question 48

Module 10.6 LOS 10e

Which adjustments an analyst may need to do when comparing financial statements between two companies

Answer 48

1. Net versus gross pension assets and liabilities
2. Differencies in actuarial assumptions which impact periodic pension cost amount
3. Restate from GAAP to IFRS income vs OCI
4. Restate from GAAP to IFRS in operating expense vs inrerest part of PnL.

Question 49

Module 10.6 LOS 10e
What are the differencies in GAAP and IFRS regarding where to report periodic pension cost in PnL (interest vs operating income)?

Answer 49

GAAP - all PnL parts of periodic pension costs are reported on operating income
IFRS - only service cost is an operating expense, others are in interest result.

Question 50

Module 10.6 LOS 10f
In which cases should reclassification from CFO to CFF happen with regards to accounting of defined benefit pension plan? Ho adjustment is done?

Answer 50

When difference between contributions and TPPC is material.
Example: if TPPC > contributions -> borrowing,
adj. CFO = CFO - (1-t)(TPPC-contributions)
adj. CFF = CFF + (1-t)(TPPC-contributions)

Question 51

Module 10.2, LOS 10.b

Under US GAAP what should company disclose in footnotes about defined plan assumptions?

Answer 51

Discount rate, the expected return on plan assets, and the rate of compensation growth

Question 52

Module 11.1, LOS 11.a

Which currencies are envolved in multinational accounting?

Answer 52

1) local currency - currency of the country being referred to
2) functional currency - currency in which the entity operates (generates and expends cash), chosen by management
3) presentation (reporting) currency - currency in which the parent company prepares its financial statements

Question 53

Module 11.1, LOS 11.b
Where foreign currency transaction gains/losses are recognised in:
1) IFRS?
2) GAAP?

Answer 53

In both IFRS and GAAP it should be recorded on payment date in PnL, but neither specify, where exactly in PnL

Question 54

Module 11.2, LOS 11.c, LOS 11.d
What are the methods to translate statements between subsidiary and parent companies and in which cases are they applied?

Answer 54

1) translation, current method parent reporting cur. - often used for more independent subsidiaries
2) remeasurement, temporal method (functional cur. = parent reporting cur.)
3) remeasurement, temporal method + translation, current method

Question 55

Module 11.2, LOS 11.c, LOS 11.d
When subsidiary operates in hyperinflationary environment, how translation of statements fro subsidiary to parent currency should be done in:
1) IFRS?
2) GAAP?

Answer 55

1) IFRS - subsidiary’s financial statements are restated for inflation and then translated using the current rate method
2) GAAP - the functional currency is considered to be the parent’s presentation currency, and the temporal method is used

Question 56

Module 11.3, LOS 11.c, LOS 11.d
Under temporal method of currency translation, at which exchange rates different BS and income statement elements are translated?

Answer 56

1) Monetary assets (cash, receivables, payables, and ST, LT debt) - current rate
2) Non-monetary A and L reported at FV - current rate
3) Non-monetary A and L not reported at FV (common types - inventory, fixed assets, and intangible assets) - historical rate
4) common stock and dividends paid - historical rate
5) All expenses linked to non-monetary A - historical rate
6) All other revenues and expenses - average rate

Question 57

Module 11.3, 11.4, LOS 11.c, LOS 11.d
In currency translation, where translation/remeasurement gains/losses are reported:
1) under temporal method?
2) under current rate nethod?

Which method gives more volatile PnL?

Answer 57

1) Temporal method - PnL
2) Current rate method - shareholders’ equity, under CTA (cumulative translation adjustment)

Temporal method gives more volatile PnL

Question 58

Module 11.4, LOS 11.c, LOS 11.d
Under current rate method of currency translation, at which exchange rates different BS and income statement elements are translated?

Answer 58

1) All BS except common stock and dividend- current rate
2) Common stock - historical method (when stock is issued)
3) Dividend - rate that applied when they were declared
4) All PnL - average rate

Question 59

Module 11.4, LOS 11.c, LOS 11.d
What is the net exposure:
1) under temporal method?
2) under current rate nethod?

Answer 59

1) temporal method - net monetary assets

2) current rate nethod - net assets

Question 60

Module 11.6, LOS 11.f

What is the main tip to understand if the translation will impact financial ratio or not under current method?

Answer 60

If this is a pure BS or pure PnL ratio, then there will bw no impact.
For mixed ratios it is not the case

Question 61

Module 11.7, LOS 11.g

1) What is considered hyperinflation in GAAP and IFRS? Where adjustment for hyperinflation is allowed?
2) How adjustment for inflation in BS and PnL is done in case of hyperinflation?

Answer 61

1) GAAP compounded inflation over 3 consecutive periods is 100% and over (~26% per year). IFRS - not defined. Adjustment is allowed in IFRS only.

2) - All non-monetary A and L are restated as (* price index to acquisition date)
- Equity (except NI in RE part) restated as (price index to beginning of period)
- Monetary A and L are not restated
- NI restated as (price index to transaction date)
- Purchase power gain/loss is recognized in PnL (either to balance A and L, either as delta in price index * all monetary A and L)

Inflation adjustment method has similarities to temporal method

Question 62

Module 11.7, LOS 11.g

What is clean-surplus accounting and dirty-surplus?

Answer 62

Clean-surplus accounting - including the gains and losses (that are reported in shareholders’ equity) in net income.
Dirty-surplus - gains and losses reported in shareholders’ equity.

Question 63

Module 12.1, LOS 12.b

Which organisations control stability of financial institutions?

Answer 63

1. Basel Committee on Banking Supervision (develops the regulatory framework for banks )
2. Financial Stability Board (coordinates actions of participating jurisdictions in identifying and managing systemic risks)
3. International Association of Deposit Insurers (improves the effectiveness of deposit insurance systems)
4. International Organization of Securities Commissions (IOSCO) (promotes fair and efficient security markets)
5. International Association of Insurance Supervisors (IAIS) (which seeks to improve supervision of the insurance industry)

Question 64

Module 12.2, LOS 12.с
How equity securities are accounted in:
1) IFRS?
2) GAAP?

Answer 64

1) IFRS - FV in OCI or PnL

2) GAAP - FV in PnL

Question 65

Module 12.3, LOS 12.с

When estimating earnings quality, which levels of inputs for FV estimation are distinguished?

Answer 65

1) Level 1 - inputs are quoted market prices of identical assets
2) Level 2 - inputs are observable but not quoted prices of identical assets
3) Level 3 - inputs are non-observable and hence subjective

Question 66

Module 12.4, LOS 12.с

What are AFS factors in NSFR?

Answer 66

1. Regulatory capital minus Tier 2 instruments maturing in a year - 100%
2. Other capital instruments and liabilities with maturity > 1 year - 100%
3. Stable demand deposits and term deposits (maturity < 1 year) from retail and small business customers -95%
4. Less-stable demand deposits and term deposits (maturity < 1 year) from retail and small business customers 90%
5. Funding from non-financial corporates (maturity < 1 year), operational deposits, funding from sovereigns, public sector (maturity < 1 year), multilateral and national development banks - 50%

Question 67

Module 12.6, LOS 12.f

What are the key P&C insurers profitability ratios? What is the difference in IFRS and GAAP for these ratios?

Answer 67

1. 1. underwriting loss ratio = (claims paid + delta loss reserves)/net premium earned
2. 2. loss and loss adjustment expense ratio = (loss expense + loss adjustment expense)/net premium earned
3. expense ratio (or underwriting expense ratio) = underwriting expenses including commissions/(net premium written in IFRS) or (net premium earned in GAAP)
4. combined ratio = (1.1 or 1.2) + 2
5. dividends to policyholders ratio - dividends to policy holders (shareholders)/net premium earned
6. CRAD = combined ratio + dividends to policyholders ratio

Question 68

Module 12.6, LOS 12.f

1) What does underwriting loss ratio measure?
2) What does underwriting expense ratio measure?
3) What does dividends to policyholders ratio measure?
4) What does combined ratio measure?
5) What does CRAD measure?

Answer 68

1) underwriting loss ratio (or loss and loss adjustment expense ratio) measures the relative efficiency of the company’s underwriting standards
2) expense ratio measures the efficiency of the company’s operations
3) dividends to policyholders - liquidity measure measuring cash outflow on account of dividends relative to premium income.
4) combined ratio indicates if low -> hard market, if high -> soft market
5) CRAD - measures total efficiency

Question 69

Module 12.6, LOS 12.f

What are the key P&C and L&H insurers investment performance ratios?

Answer 69

1) total investment return ratio = total investment income ÷ invested assets
2) total investment return (w/o unrealized gains/losses) ratio = (total investment income excl. unrealized income) ÷ invested assets

Question 70

Module 12.6, LOS 12.f

What is the capital requirement for P&C insurers?

Answer 70

No global risk-based capital requirement standards
Regionally, the E.U. has adopted the Solvency II standards, while NAIC in the United States has specified minimum capital levels based on size and risk

Question 71

Module 12.6, LOS 12.f

What are the important L&H insurers profitability ratios?

Answer 71

1) total benefits paid / net premiums written and deposits

2) commissions and expenses / net premiums written and deposits

Question 72

Module 12.6, LOS 12.f

What is the main L&H insurers liquidity measure? Is liquidity risk higher for L&H insurers or P&C insurers?

Answer 72

1) Adjusted investment assets/adjusted obligations

Assets are adjusted based on their ready convertibility into cash, obligations are adjusted based on assumptions about withdrawals

2) Liquiduty risk is relatively low for L&H compared to P&C

Question 73

Module 12.6, LOS 12.f

What is the main L&H insurers risk?

Answer 73

Interest rate risk - due to duration mismatches between assets and liabilities for L&H insurers

Question 74

Module 13.1, LOS 13.a

List financial reports quality categories (High to Low)

Answer 74

1. GAAP compliant and decision-useful, high-quality earnings
2. GAAP compliant and decision-useful, low-quality earnings
3. GAAP compliant but not decision-useful (biased choices)
4. Non-compliant accounting
5. Fraudulent accounting

Question 75

Module 13.1, LOS 13.b

Where potential problems that affect the quality of financial reports may arise from? what is the effect difference?

Answer 75

1) Measurement and timing issues and/or - usually impact many items in BS and PnL
2) Classification issues - mostly impact one line/item

Question 76

Module 13.2, LOS 13.c, 13.d

What are the 2 major models to measure the quality of a company’s financial reports? What is their major disadvantage?

Answer 76

1) Beneish probit regression Model
2) Altman’s Z-score

Models use accounting data which may be uninformative;
They are one-period models;
Beneish has 2 variables with unexpected sign

Question 77

Module 13.2, LOS 13.c, 13.d

What are the key components of Beneish model?

Answer 77

Positive sign

1) DSRI - days of sales receivables growth
2) GMI - gross margin growth index
3) AQI - assets quality index (non-current assets - PPE) / total A
4) SGI - sales growth index
5) DEPI - changes in depreciation expense / (depreciation+PPE)
6) Accruals - (income before extraordinary items − cash flow from operations) / total assets

Negative sign

7) SGAI - changes in SGA expenses (as a % of sales)
8) Leverage - changes in D/A

Question 78

Module 13.2, LOS 13.c, 13.d

In Beneish model, what is the threshold level of M-score and how to interpret deviations from it?

Answer 78

threshold = -1.78

if less negative result - higher than exceptable probability of manipulation

Question 79

Module 13.2, LOS 13.c, 13.d

What are the key components of Altman’s model?

Answer 79

Positive sign

1) NWC/A
2) Sales/A
3) Operating profit/A
4) RE/A
5) FV of equity / BV of liabilities

the more the value - of model - the lower the bankruptsy probability

Question 80

Module 13.2, LOS 13.f

What are the indicators of earnings quality?

Answer 80

1) Sustainable: high-quality earnings tend to persist in the future
2) Adequate: high-quality earnings cover the company’s cost of capital.

Question 81

Module 13.2, LOS 13.e

How to measure if earnings are stable?

Answer 81

1) earnings(t+1) = α + β1 earnings(t) + ε

2) earnings(t+1) = α + β1 cash flow(t) + β2accruals(t) + ε

Question 82

Module 13.3, LOS 13.g

How the accruals component of earnings affects the speed of mean reversion?

Answer 82

The higher the accruals component, the faster the reversion will happen

Question 83

Module 13.4, LOS 13.i

What are the indicators of CF quality?

Answer 83

1) reported cash flow was high (i.e., good economic performance) - if it is not an early stage start-up
2) the underlying reporting quality was also high

Question 84

Module 13.5, LOS 13.k

What are the indicators of BS quality?

Answer 84

1) Completeness
2) Unbiased Measurement
3) Clear Presentation

Question 85

Module 13.5, LOS 13.m

Name sources of information about risk

Answer 85

1) Financial statements
2) Auditor’s report
3) Notes to financial statements
4) Management Discussion and Analysis (MD&A)
5) SEC Form ‘NT’
6) Financial press

Question 86

Module 14.2, LOS 14.b, 14.c

When analysing financial performance of a company separately from result of it’s subsidiary, should you adjust equity?

Answer 86

Only when it is specified, what were the funding sources of investment.
Otherwise, do not adjust the financial leverage, assume that the investment in associate used the same capital structure (i.e., mix of debt and equity) as the parent company.

Question 87

Module 14.4, LOS 14.b, 14.c

What does the ratio of capital expenditures %/assets % show?

Answer 87

It shows how much resources is allocated to business compared to it’s assets share
>1 - the firm is growing the segment by allocating a greater percentage of its capital expenditures to a segment than that segment’s proportion of total assets
<1 - the firm is allocating a smaller percentage of its capital expenditures to a segment than its proportion of total assets

Question 88

Module 14.4, LOS 14.b, 14.c
How can you measure capital allocation decision efficiency from cash generation perspective? Should you use EBIT for estimation?

Answer 88

1) EBIT may not be a good indicator of an entity’s ability to generate cash flow because of accruals
2) Take Estimated Cash Flow = EBIT + Depreciation/Amortization
3) Use Estimated Cash Flow/Average Assets as a proxi for efficiency estimation

Question 89

Module 14.5, LOS 14.d, 14.e

What are the two methods how to calculate accruals ratios?

Answer 89

1) BS method - accruals ratio = (change in NOA)/(avg.NOA)
NOA = OA - OL
OA = TTL A - cash - equivalents of cash - marketable sec.
OL = TTL L - TTL debt
2) CF method - accruals ratio = (NI − CFO − CFI)/(avg. NOA)

Question 90

Module 14.5, LOS 14.d, 14.e

How cash generated from operations (CGO) is estimated for comparison with operating profit?

Answer 90

CGO = EBIT + non-cash charges − increase in working capital

non-cash charges - taxes and interest - only need to add back if they were initially recognized as CFO (not CFF)

Question 91

How to estimate implied P/E ratio of he parent company?

Answer 91

implied P/E = implied parent value / (parent net income − equity income from subsidiary)
parent implied value = parent MV - %shareFXsubsidiary MV

Question 92

Module 14.2, LOS 14.b

How would an increase in depreciation impact inventory turnover ratio?

Answer 92

Depreciation will only affect inventory turnover if depreciation has been allocated to individual inventory items