Financial Reporting & Analysis Flashcards
Investment in financial assets
Ownership interest of less than 20% is usually considered a passive investment - i.e. investor cannot significantly influence or control the investee
Reported on financial statement has either Amortized cost, FV through OCI or FV through profit or loss (income statement)
Investment in associates
Ownership interest between 20-50% and typically non controlling investment. Investor can usually significantly influence the investee’s business operations
Using equity method of accounting for financial statement reporting
Business combinations
An ownership interest of more than 50% is usually a controlling investment.
The acquisition method of account is used for reporting financial statements
Joint ventures
An entity whereby control is shared by two or more investors. Both IFRS and US GAAP require the equity method for joint ventures.
In rare occurrence, proportionate consolidation method may be allowed. Investor only reports the proportionate shares of assets, liabilities, revenues and expenses. No minority owner’s interest is reported.
Amortized cost (debt securities only)
An IFRS 9 classification
Debt security that meet below two criteria use this method for financial reporting on balance sheet
- Debt securities are being held to collect contractual cash flows
- Contractual cash flows are either principal or interest on principal, only
Interest income from holding debt is recognized in the income statement
Fair Value Through Profit or Loss
Debt securities can be classified as such if held for trading
Equity securities held for trading are required to be classified as such
Changes in fair value, realized or unrealized, are recognized in the income statement along with any dividend or interest income
Fair Value through OCI (Debt and Equity Securities)
Securities classified as fair value through OCI are carried on the balance sheet @ fair value
Unrealized gain or loss in OCI
Realized gain or loss, dividends, and interest income are reported in the income statement
Reclassification of Debt Securities (IFRS 9)
Amortized cost to FVPL
Unrecognized gains/loss on debt securities recognized on the income statement
FVPL to Amortized Cost
Debt securities reclassified are transferred at fair value on the transfer date and will become the carrying amount - i.e. if at time of transfer FV > purchase price, treat as amortized premium vice versa
Equity Method of Accounting
Referred to as one-line consolidation, one line in parent company’s balance sheet and one line in parent company’s income statement
Fair Value Option (US GAAP vs IFRS) - Equity Method
Under US GAAP, equity method of account for investments are allowed to be recorded at fair value.
Under IFRS, fair value option is only available to venture capital firms, mutual funds, and similar entities.
Reporting as fair value is irrevocable and changes in value are recorded in the income statement
Equity Method Impact to B/S and I/S
- Record initial amount of investment on B/S
- Add proportionate share of income received to initial amount of investment
- Reduce investment account by proportionate share of dividend received
- Record proportionate share of income received on I/S
Partial goodwill calculation (Equity Method)
IFRS Only
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Purchase Price
Pro-rata BV Net Assets
=Excess Purchase Price
(Pro-rata FV - BV)
=Goodwill
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Analytical Issues for Investment in Associates
- When investee is profitable and dividend payout ratio is less than 100%, equity method results in higher earnings
- B/S and I/S reporting in one line ignores the investee’s debt and therefore, lower leverage. In addition, margin ratios are high since investee’s revenue is ignored.
- Investee’s earnings through dividends may not always be cash flow and can be permanently treated as a reinvestment.
Merger
Acquiring firm absorbs all the assets and liabilities of the acquired firm, which ceases to exist. The acquiring firm is the surviving entity.
Acquisition
Both entities continue to exist in a parent-subsidiary relationship.
When <100% of the subsidiary is owned by the parent, the parent prepares consolidated financial statement but reports (minority or non controlling) interest on its financial statement
Consolidation
A new entity is formed that absorbs both of the combining companies
Calculate minority interest (Acquisition Method)
(SE x %minority interest)
+ (NI x %minority interest)
- (Dividends x %minority interest)
Defined contribution plan
retirement plan whereby the firm contributes a certain sum each period to the employee’s retirement account
Defined benefit plan
the firm promises to make periodic payments to the employee after retirement
based on employee’s years of service and compensation near retirement
funded status of the plan
FV of plan assets - PV of DBO
Underfunded = net pension liability on B/S Overfunded = net pension asset on B/S
Net pension asset is subject to ceiling, aka PV of future economic benefits
Proportionate consolidation vs. Equity Method Impact on B/S and I/S
Balance Sheet:
Proportionate consolidation (aka acquisition) reports higher assets and liabilities than Equity method but reports the same Shareholder Equity (i.e. net assets)
Income Statement:
Proportionate consolidation (aka acquisition) reports higher revenues and expenses than Equity method but reports the same net income
How to Calculate Unearned Profit on Downstream Sale for Equity Income on I/S
- Calculate Investors net profit from downstream sale
- Determine % unsold (if partial sales)
- Determine total unrealized profit ( %unsold x net profit from downstream sale)
- Reduce pro-rata share of investee’s net income by unrealized profit
Upstream Sale
Transaction between two affiliates. The associate sells to the investor.
Profit of the inter company transaction is recorded on the associate’s income statement.
Investor’s share of unrealized profit is included in equity income on the investor’s income statement
Downstream Sale
Transaction between two affiliates; the investor sells to the associate.
The profit is recorded on the investor’s income statement. Both IFRS and US GAAP require unearned profits be eliminated to the extent of investor’s equity interest in associate
Full Goodwill
Used by IFRS and US GAAP
FV of Entity
FV of identifiable assets
=goodwill
Recognition and Measurement when Acquisition Price is Less than Fair Value
IFRS AND US GAAP require the difference between fair value of the acquired net assets and the purchase price to be recognized immediately as a gain in profit or loss
Non-controlling Asset Valuation (Acquisition/Consolidation method)
Under acquisition method (IFRS and US GAAP), as long as the parent has control over subsidiary, it would control 100% of the subsidiary’s assets and liabilities at fair value
Goodwill = FV of the subsidiary - FV of the subsidiary’s net identifiable assets
Non-controlling interest = non-controlling interest% x fair value of the subsidiary
Impact of goodwill method on B/S ratios
Return on assets and return on equity under partial goodwill method is higher than full goodwill due to impact from non-controlling interest
Impairment loss (IFRS)
Reported on consolidated income statement
Recoverable amount minus the carrying (book) value
Impairment loss is first applied to the good will of the cash generating unit of a company. Once reduced to zero, remaining loss is then allocated to all of the other non-cash assets in the unit
Impairment loss - US GAAP
Reported on consolidated income statement
- Check for impairment: Carrying value > FV?
- Measure impairment loss: FV of goodwill (implied) - carrying value of goodwill
Loss applied only to the reporting unit to which the goodwill has been allocated to.
Contingent Assets & Liabilities: IFRS vs. US GAAP
Not recognized under IFRS.
Under US GAAP, contractual contingent assets and liabilities are recognized and recorded at their fair values at the time of acquisition
Vesting
Provision in pensions plans whereby an employee gains rights to future benefits only after meeting certain criteria (e.g. pre-specified numbers of years of service)
Periodic Pension Cost (IFRS)
Change in the net pension liability or asset adjusted for the employer’s contributions.
3 components:
- Service Cost
- Net interest expense/income
- Remeasurement
Service Cost
Component of periodic pension cost
Represents obligation of company for current and past services rendered by employee
Under IFRS, it is recognized on I/S for both past and current
Under US GAAP, current service cost recognized in I/S and past service cost recognized in OCI and amortized to I/S over the average service lives of employees in subsequent periods
Net interest expense
Represents the financing cost of deferring payments related to the plan
Component of periodic pension cost
Calculated by multiplying net pension liability by discount rate used for calculating PV of pension liability
Under IFRS, reported on the I/S
Net interest Income
Represents the financing income of prepaying amounts related to the plan
Component of periodic pension cost
Calculated by multiplying net pension asset by discount rate used for calculating PV of pension liability
Under IFRS, reported on the I/S
Under US GAAP, known as expected return on plan assets, also reported on I/S
Remeasurement
3rd component of period pension cost
Remeasurement of net pension liability or asset, which includes:
- Changes in actuarial assumptions (i.e. actuarial gains and losses)
Differences between expected return and actual return on plan assets (US GAAP Only)
- Any differences between the actual return on plan assets and the amount included in the net interest expense/income calculation
Under IFRS, recognized in OCI
Corridor approach (US GAAP Only)
Process in which companies will compare net cumulative actuarial gains/loss w/ DBO and FV of plan assets at the beginning of the period
If cumulative amount exceeds 10% of greater of DBO or FV of plan assets at beginning of period, the amount in excess of 10% is amortized over the expected avg remaining working lives of employees
It will be included as a component of periodic pension cost on the I/S
Periodic Pension Cost on I/S (US GAAP)
Current service cost
+ interest cost (PBO beginning of period x discount rate)
- expected return on assets
Fair Market Value of Plan Assets Calculation (IFRS)
Periodic pension cost =
beginning PBO -service cost -interest cost \+benefits paid =End PBO
Plan assets =
Beginning plan assets
+actual return on plan assets
+benefits paid
= ending value of plan assets
Total Periodic Pension Cost
Contributions - change in funded status
Change in fund status =
(End FV plan assets - Beg FV plan assets) - (end PBO - beg PBO)
OR
Current service cost + interest cost - actual investment return (instead of expected return); consider it as the final cost as opposed to estimated
Pension contribution impact to cash flows
If contributions exceed total periodic pension cost, the difference should be treated similar to an excess principal payment on a loan
Since principal payments are reported as financing activities, increase operating cash flow and decrease financing cash flow
Note: adjustment to cash flow with excess contribution needs to be after-tax
Reclassifying pension cost for analytical purposes
Treatment of periodic pension cost differ between IFRS and US GAAP.
Adjust operating income by adding back period pension cost and only subtracting current service cost
Interest cost should be added to interest expense
Actual return on plan assets added to non operating income
SFAS No. 123(R) - Employee Stock options
Firms are required to use the fair value method of valuing stock option plans. In the absence of a market-based instrument, firms may select and use an option-pricing model such as the Black-Scholes, binomial, or Monte Carlo
Compensation expense is not affected when options are exercised.
Companies will be required to spread the compensation cost over the vesting period equally
Temporal Method (aka Remeasurement)
The local currency is different from the functional currency. The functional currency is the same as the parent company reporting currency
Occurs when a subsidiary is well integrated with the parent. The parent makes the operating, investing, and financing decisions.
Current Method (aka Translation)
The local currency and the functional currency are the same and requires converting to the parent company’s reporting currency
Usually occurs when subsidiary is independent and operating, investing, and financing activities are decentralized from parent
US GAAP vs. IFRS treatment of translation of currencies on financial statement
Subsidiary needs to be operating in a hyper inflationary environment.
Under US GAAP, functional currency = reporting currency and use temporal method
Under IFRS, subsidiary’s financial statements are restated for inflation and then use current method.
B/S and I/S Impact under Temporal Method
Monetary A + L -> Current Exch
E.g. cash, receivables, payables, short-term and long-term debt
Non monetary A+L -> Historical Exch
E.g., Inventory, FA, intangible assets, unearned revenue
Common stock, dividends, COGS, dep/amortized expense -> Historical Exch
Revenue/Other exp -> Avg Exch
Translation G/L - > reported on I/S
B/S and I/S impact using Current Rate Method
All I/S -> Avg Exch rate
All B/S -> Current Exch rate
Common stock & Div -> Historical Exch rate
Translation G/L -> CTA in Shareholder Equity
Method required under US GAAP in inflationary environment
Temporal method
Common Equity Tier 1 ratio
Common equity tier 1 / risk weighted assets
Most important source of capital for a bank
Common Equity Tier capital
Includes:
- Common stock
- Additional paid-in capital
- Retained earnings
- OCI
- Adjustments related to deduction for intangible assets & deferred tax assets
Total % of risk-weighted assets under Basel III guidelines for Tier 1 capital
6% of risk-weighted assets
Level 1 inputs (valuation of securities)
Quoted market prices of identical securities
What does Net Stable Funding Ratio measure?
NSFR is the ratio of available stable funding sources (nominator) to the required stable fund (denominator)
It measures liquidity of funding sources relative to liquidity needs of the assets
The standard sets a target minimum of greater than 100%
Loss and loss adjustment expense ratio
Loss and loss adjustment expense / net premiums written
Underwriting expense ratio
Indicator of the efficiency of a company’s operation in acquiring and managing underwriting business
Underwriting expense (incl. sales commissions and related employee expenses) / net premiums written
Total Capital
Tier 1 capital + Tier 2 capital
Must be at least 8% of risk-weighted assets
Level 2 inputs
Observable and include quoted prices for similar financial instruments in active markets, quoted prices for identical financial instruments in markets that are NOT active, other observable data such as rates, yield curves, credit spread, and implied volatility
Level 3 inputs
NOT observable
Fair value for an instruments is based on a model
Liquidity Coverage Ratio (LCR)
Expressed as the minimum % of bank’s expected cash outflows that must be held in highly liquid assets.
Expected cash outflows are bank’s anticipated one-month liquidity needs in a stress scenario
Standard is a target minimum of 100%
Allowance for loan losses
Balance sheet account and a contra asset account to loans
Total loans - allowance for loan losses = expected value of the loans
**critical accounting estimate
Provisions for loan losses
Income statement expense account that increases the amount of the allowance for loan losses
ACTUAL loan losses REDUCE the amount of the allowance for loan losses
Soft vs hard pricing market for P&C insurance companies
Price cutting drives out profitability, which leads to insurers reaching depleted level of capital.
Once that occurs, competition lessens and underwriting standards tighten.
Once that occurs, premiums rise and insurers return to more reasonable levels of profitability.
This cycle continuous…
Combined Ratio
(Loss and loss adjustment expense ratio + underwriting expense ratio)
A low combined ratio indicates a “hard insurance market”
A combined ratio higher than 100% for a single insurer indicates a underwriting loss
Dividends to shareholders ratio
Dividends to policyholders / net premiums earned
LIFO Liquidation
Slowing the purchase of inventory items so that older lower costs are used to calculate COGS.
Financial Statement Impact
Reduce COGS
Reduce Inventory
Artificially increase gross and net margins
Inventory turnover ratio likely increased (%decrease if inventory > %decrease in COGS)
Classification of Debt Securities (IFRS 9)
Debt securities can be classified at amortized cost (if business model and cash flow characteristic test is met), FV OCI, or FV through P/L
Reclassification of Equity Securities
NOT ALLOWED
Initial designation of FVPL or FVOCI is irrevocable
When local currency, functional currency, and reporting currency are all different
Two step conversion:
- Convert local currency to functional currency using temporal method (Think 1 to 2)
- Convert functional currency to presentation currency using current method (think 2 to 1)
Aggregate accruals using cash flow method
NI - CFO - CFI / (NOAend + NOAbeg)/2
Accruals ratio using balance sheet approach
- Calculate beginning and ending Net Operating Assets (Net Operating Assets - Net Operating Liabilities)
- (NOAend - NOAbeg) / {(NOAend - NOAbeg)/2}
If a company wished to pay off all of its debt while maintaining existing reinvestment, determine the number of years it would take to do so
Years to repay debt from operating cash flow =
Total debt / (CFO - reinvestment)
Reinvestment - All CapEx
What business segment is the company’s management looking to grow?
Compare the segment CapEx as a % of total CapEx to the Segment assets as a % of total assets
Ratio = % of CapEx / % of total assets
If >1, it indicates that a segment is being allocated a greater proportion of CapEx than its proportion of assets and is therefore “growing”
ROE (extended DuPont)
Tax Burden x Interest Burden x EBIT margin x Total Asset Turnover x Financial Leverage
= (NI / EBT) x (EBT / EBIT) x (EBIT / Revenue) x (Revenue / Avg Assets) x (Avg Assets / Avg Equity)
OR after cross multiplication:
NI / Avg Equity
