Financial Reporting & Analysis

Question 1

Investment in financial assets

Answer 1

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)

Question 2

Investment in associates

Answer 2

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

Question 3

Business combinations

Answer 3

An ownership interest of more than 50% is usually a controlling investment.

The acquisition method of account is used for reporting financial statements

Question 4

Joint ventures

Answer 4

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.

Question 5

Amortized cost (debt securities only)

Answer 5

An IFRS 9 classification

Debt security that meet below two criteria use this method for financial reporting on balance sheet

1. Debt securities are being held to collect contractual cash flows
2. Contractual cash flows are either principal or interest on principal, only

Interest income from holding debt is recognized in the income statement

Question 6

Fair Value Through Profit or Loss

Answer 6

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

Question 7

Fair Value through OCI (Debt and Equity Securities)

Answer 7

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

Question 8

Reclassification of Debt Securities (IFRS 9)

Answer 8

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

Question 9

Equity Method of Accounting

Answer 9

Referred to as one-line consolidation, one line in parent company’s balance sheet and one line in parent company’s income statement

Question 10

Fair Value Option (US GAAP vs IFRS) - Equity Method

Answer 10

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

Question 11

Equity Method Impact to B/S and I/S

Answer 11

1. Record initial amount of investment on B/S
2. Add proportionate share of income received to initial amount of investment
3. Reduce investment account by proportionate share of dividend received
4. Record proportionate share of income received on I/S

Question 12

Partial goodwill calculation (Equity Method)

Answer 12

IFRS Only

```
Purchase Price
Pro-rata BV Net Assets
=Excess Purchase Price
(Pro-rata FV - BV)
=Goodwill
~~~

Question 13

Analytical Issues for Investment in Associates

Answer 13

1. When investee is profitable and dividend payout ratio is less than 100%, equity method results in higher earnings
2. 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.
3. Investee’s earnings through dividends may not always be cash flow and can be permanently treated as a reinvestment.

Question 14

Merger

Answer 14

Acquiring firm absorbs all the assets and liabilities of the acquired firm, which ceases to exist. The acquiring firm is the surviving entity.

Question 15

Acquisition

Answer 15

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

Question 16

Consolidation

Answer 16

A new entity is formed that absorbs both of the combining companies

Question 17

Calculate minority interest (Acquisition Method)

Answer 17

(SE x %minority interest)
+ (NI x %minority interest)
- (Dividends x %minority interest)

Question 18

Defined contribution plan

Answer 18

retirement plan whereby the firm contributes a certain sum each period to the employee’s retirement account

Question 19

Defined benefit plan

Answer 19

the firm promises to make periodic payments to the employee after retirement

based on employee’s years of service and compensation near retirement

Question 20

funded status of the plan

Answer 20

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

Question 21

Proportionate consolidation vs. Equity Method Impact on B/S and I/S

Answer 21

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

Question 22

How to Calculate Unearned Profit on Downstream Sale for Equity Income on I/S

Answer 22

1. Calculate Investors net profit from downstream sale
2. Determine % unsold (if partial sales)
3. Determine total unrealized profit ( %unsold x net profit from downstream sale)
4. Reduce pro-rata share of investee’s net income by unrealized profit

Question 23

Upstream Sale

Answer 23

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

Question 24

Downstream Sale

Answer 24

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

Question 25

Full Goodwill

Answer 25

Used by IFRS and US GAAP | FV of Entity FV of identifiable assets =goodwill

Question 26

Recognition and Measurement when Acquisition Price is Less than Fair Value

Answer 26

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

Question 27

Non-controlling Asset Valuation (Acquisition/Consolidation method)

Answer 27

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

Question 28

Impact of goodwill method on B/S ratios

Answer 28

Return on assets and return on equity under partial goodwill method is higher than full goodwill due to impact from non-controlling interest

Question 29

Impairment loss (IFRS)

Answer 29

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

Question 30

Impairment loss - US GAAP

Answer 30

Reported on consolidated income statement 1. Check for impairment: Carrying value > FV? 2. 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.

Question 31

Contingent Assets & Liabilities: IFRS vs. US GAAP

Answer 31

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

Question 32

Vesting

Answer 32

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)

Question 33

Periodic Pension Cost (IFRS)

Answer 33

Change in the net pension liability or asset adjusted for the employer’s contributions. 3 components: 1. Service Cost 2. Net interest expense/income 3. Remeasurement

Question 34

Service Cost

Answer 34

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

Question 35

Net interest expense

Answer 35

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

Question 36

Net interest Income

Answer 36

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

Question 37

Remeasurement

Answer 37

3rd component of period pension cost Remeasurement of net pension liability or asset, which includes: 1. Changes in actuarial assumptions (i.e. actuarial gains and losses) Differences between expected return and actual return on plan assets (US GAAP Only) 2. 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

Question 38

Corridor approach (US GAAP Only)

Answer 38

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

Question 39

Periodic Pension Cost on I/S (US GAAP)

Answer 39

Current service cost + interest cost (PBO beginning of period x discount rate) - expected return on assets

Question 40

Fair Market Value of Plan Assets Calculation (IFRS)

Answer 40

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

Question 41

Total Periodic Pension Cost

Answer 41

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

Question 42

Pension contribution impact to cash flows

Answer 42

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

Question 43

Reclassifying pension cost for analytical purposes

Answer 43

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

Question 44

SFAS No. 123(R) - Employee Stock options

Answer 44

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

Question 45

Temporal Method (aka Remeasurement)

Answer 45

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.

Question 46

Current Method (aka Translation)

Answer 46

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

Question 47

US GAAP vs. IFRS treatment of translation of currencies on financial statement

Answer 47

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.

Question 48

B/S and I/S Impact under Temporal Method

Answer 48

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

Question 49

B/S and I/S impact using Current Rate Method

Answer 49

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

Question 50

Method required under US GAAP in inflationary environment

Answer 50

Temporal method

Question 51

Common Equity Tier 1 ratio

Answer 51

Common equity tier 1 / risk weighted assets

Question 52

Most important source of capital for a bank

Answer 52

Common Equity Tier capital Includes: 1. Common stock 2. Additional paid-in capital 3. Retained earnings 4. OCI 5. Adjustments related to deduction for intangible assets & deferred tax assets

Question 53

Total % of risk-weighted assets under Basel III guidelines for Tier 1 capital

Answer 53

6% of risk-weighted assets

Question 54

Level 1 inputs (valuation of securities)

Answer 54

Quoted market prices of identical securities

Question 55

What does Net Stable Funding Ratio measure?

Answer 55

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%

Question 56

Loss and loss adjustment expense ratio

Answer 56

Loss and loss adjustment expense / net premiums written

Question 57

Underwriting expense ratio

Answer 57

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

Question 58

Total Capital

Answer 58

Tier 1 capital + Tier 2 capital Must be at least 8% of risk-weighted assets

Question 59

Level 2 inputs

Answer 59

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

Question 60

Level 3 inputs

Answer 60

NOT observable Fair value for an instruments is based on a model

Question 61

Liquidity Coverage Ratio (LCR)

Answer 61

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%

Question 62

Allowance for loan losses

Answer 62

Balance sheet account and a contra asset account to loans Total loans - allowance for loan losses = expected value of the loans **critical accounting estimate

Question 63

Provisions for loan losses

Answer 63

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

Question 64

Soft vs hard pricing market for P&C insurance companies

Answer 64

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...

Question 65

Combined Ratio

Answer 65

(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

Question 66

Dividends to shareholders ratio

Answer 66

Dividends to policyholders / net premiums earned

Question 67

LIFO Liquidation

Answer 67

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)

Question 68

Classification of Debt Securities (IFRS 9)

Answer 68

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

Question 69

Reclassification of Equity Securities

Answer 69

NOT ALLOWED Initial designation of FVPL or FVOCI is irrevocable

Question 70

When local currency, functional currency, and reporting currency are all different

Answer 70

Two step conversion: 1. Convert local currency to functional currency using temporal method (Think 1 to 2) 2. Convert functional currency to presentation currency using current method (think 2 to 1)

Question 71

Aggregate accruals using cash flow method

Answer 71

NI - CFO - CFI / (NOAend + NOAbeg)/2

Question 72

Accruals ratio using balance sheet approach

Answer 72

1. Calculate beginning and ending Net Operating Assets (Net Operating Assets - Net Operating Liabilities) 2. (NOAend - NOAbeg) / {(NOAend - NOAbeg)/2}

Question 73

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

Answer 73

Years to repay debt from operating cash flow = Total debt / (CFO - reinvestment) Reinvestment - All CapEx

Question 74

What business segment is the company’s management looking to grow?

Answer 74

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”

Question 75

ROE (extended DuPont)

Answer 75

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