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CFA Level 2 > Financial Reporting Analysis > Flashcards

Financial Reporting Analysis Flashcards

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1
Q

Soft pricing

the P&C insurance business is price-sensitive and cyclical where competitors are unafraid to cut prices to win business

A

Soft pricing: Price cutting drives out profitability creating a ‘soft’ market. Insurers reach a depleted level of capital.

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2
Q

Hard pricing

the P&C insurance business is price-sensitive and cyclical where competitors are unafraid to cut prices to win business

A

Hard pricing: Lessening of competition, underwriting standards tighten, creating a ‘hard’ pricing market. Premiums rise and profitability restored.

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3
Q

Equity Method

A
  • Stakes of between 20% and 50% and joint ventures are generally reported using the equity method
  • To avoid the opportunity for the company to trade with its associate just to boost profits, profit cannot be recognized on the income statement until sale of the goods to a third party has been confirmed
  • Board representation, an interchange of personnel or technological dependency could all signify significant influence, making the use of the equity method more likely.
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4
Q

Noncontrolling (minority) interest that will be reflected under US GAAP.

A

Under US GAAP, the full goodwill method has to be used:

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5
Q

Currency translation methods

A
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6
Q

Presentation currency

A

The currency in which the financial statements are presented

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7
Q

Functional currency

A

The currency of the primary economic environment in which an entity operates. This is normally where an entity primarily spends and receives cash.

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8
Q

Local currency

A

The currency of the country in which the company operates.

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9
Q

Current rate method (‘translation’ or ‘all current’)

A
  • Functional currency is the foreign currency
  • Gains and losses direct to balance sheet through equity account (cumulative translation adjustment)
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10
Q

Temporal method (‘remeasurement’)

A
  • Functional currency is the presentation currency
  • Remeasurement gains and losses reported on income statement
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11
Q

Currency translation: Choosing the appropriate method

A
  1. Foreign currency is the functional currency (current rate method)
    • For a self-contained, independent foreign subsidiary operating in local markets, functional currency = Foreign currency
    1. Presentation currency is the functional currency (temporal method)
    • ​For a foreign subsidiary highly integrated into the parent, functional currency = Presentation currency
    • For a foreign subsidiary in h_igh inflation environment_, functional currency = Presentation currency
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12
Q

What will help an analyst to understand the drivers of tax

A

A reconciliation between the effective tax rate and statutory tax rates will help an analyst to understand the drivers of tax.

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13
Q

Reclassification of investments

A

Under IFRS 9 reclassification is allowed for debt, but not for equities (irrevocable)

Debt may be reclassified ONLY if the business model has changed to significantly change operations. When deemed appropriate, tWhen financial assets are reclassified there is no restatement of prior periods at the reclassification date.

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14
Q

Variable interest/ special purpose entities (VIE/SPE)

Definition
Application

A

Separate legal business entities established with the specific purpose of benefiting the sponsoring company. The sponsoring company might not own an equity interest in the VIE/SPE, but might hold other contractual interests (leases, loan guarantees, purchase options, etc.) that give it effective control

Application of VIE/SPEs: Receivables securitization

Classified as a VIE if:

  • Equity interest is not sufficient to allow the entity to finance itself without support from the sponsoring company (in most cases, if equity at risk is less than 10% of total assets) or
  • Equity investors lack any one of the following:
    • Ability to make decisions, or
    • Obligation to absorb losses, or
    • Right to receive residual returns
  • A sponsoring company must consolidate the VIE if it is the primary beneficiary of the entity i.e. it absorbs the majority of the risks and rewards of the VIE
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15
Q

Comparing temporal and current rate methods

A
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16
Q

Currency translation: Impact on financial ratios

Assuming the foreign currency is appreciating

A
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17
Q

Currency Translation: Effect of methods on financial ratios

A
  • For the current rate method, if the ratio is a pure balance sheet ratio or a pure income statement ratio, the ratio will remain the same after translation
  • The temporal method produces ratios that differ greatly from the foreign currency statements of the foreign subsidiary due to the mixing of current and historical exchange rates in income statement and balance sheet accounts
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18
Q

Penbsions: Net interest expense

Formula

A

Interest Cost = Discount rate x Opening obligation

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19
Q

Option valuation approach

A

Neither IFRS nor US GAAP specify the option valuation approach that must be used

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20
Q

Account for intercorporate investments

A
  • The asset is recorded as a non-current asset
  • recorded asset includes a proportionate share of the investee’s net assets and earnings.
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21
Q

Components of projected benefit obligation

  1. Service cost
  2. Interest cost
  3. Actuarial gains and losses
  4. Past/prior service cost
A
  1. Service cost = Value of benefits earned by employees during the current year. equired amount the employer must set aside each year to cover employees’ pension benefits upon retirement
  2. Interest Cost = annual interest accrued on the beginning balance of the projected benefit obligation. Interest cost = Beginning PBO x Discount rate
  3. Actuarial gains and losses = Actuarial gains and losses are created when the assumptions underlying a company’s projected benefit obligation change
  4. Past/prior service cost: Change in the PBO created by changing the pension plan benefits
22
Q

Funded status

Formula

A

Funded Status = PBO - Fair value of the plan assets

Determination of reported net liability or asset

  • If underfunded then balance sheet reflects the Net Pension Liability
  • If overfunded then balance sheet reflects the lower of Net Pension Asset or the Asset Ceiling
    • Asset ceiling equals the present value of future economic benefits such as reductions in future contributions
23
Q

Total period pension cost

Change in Funded Status adjusted for employer’s contribution

Formulas

A

TPPC = E. Contributions - Change in Funded Status (End - Begin)

TPPC = Ending PBO - Beginning PBO + Benefits paid - actual return on plan assets

24
Q

Factors affecting fair value of plan asset

A

Plan assets at the beginning of the year

+/- Actual return on plan assets

+ Employer contributions

  • Benefits paid

Plan assets at the end of the year

25
Q

Asset Ceiling

A
  • Asset ceiling equals the present value of future economic benefits such as reductions in future contributions
  • If overfunded then balance sheet reflects the lower of Net Pension Asset or the Asset Ceiling
  • “present value of available future refunds and reductions in future contributions is $150,000”
26
Q

Pension expense – income statement for US GAAP

A
27
Q

Higher compensation rate

A

Compensation promised by the pension plan is increased

28
Q

Pension expense – income statement for IFRS

A
29
Q

Share-Based Compensation

Advantages / Disadvantages

A
  • Advantages
    • Aligns managers’ interests with those of the shareholders
    • Motivates employees
    • No initial cash outlay required
  • Disadvantages
    • Managers may have limited influence over the company’s stock price, so it may not provide the desired incentive
    • Increased stock ownership may lead managers to take on low-risk projects for fear of a stock price decline
    • Alternatively, it may lead to excessive risks, as stock options only pay out if stock prices rise above the strike
    • If granted to employees, existing shareholders’ ownership is diluted
30
Q

Accounting for share-based compensation

A
  • Reported at fair value under US GAAP and IFRS
  • Disclosures required:
    • Nature and extent of share-based compensation arrangements
    • How fair value was determined
    • Effect on income and financial position
  • Two common forms of share-based compensation: Stock grants & Stock options
31
Q

Stock grants

A

​A stock grant occurs when an employer pays a part or all of the compensation of an employee in the form of corporate stock

  • A company can grant stock to employees:
    • Outright
    • With restrictions, e.g. employees must stay with the company for a certain time period
    • Contingent upon performance
  • The compensation expense is equal to the fair value (usually market value) of the shares issued at the grant date
  • The compensation expense is allocated over the employee service period
32
Q

Stock Options

A

Grant their employees is always a conventional “call option.” It gives the employee the right but not the obligation to buy the company’s stock at a predetermined price

  • Both US GAAP and IFRS require the compensation expense to be reported at fair value using a suitable option pricing model that is: (no specific model!!)
    • Consistent with fair value measurement
    • Based on established principles of financial economic theory
    • Reflective of all substantive characteristics of the award
  • The compensation expense is usually measured on the grant date, if both the number of shares and option price are known
  • If the value of options depends on events after the grant date, then the compensation expense is measured on the exercise date
33
Q

Stock Appreciation Rights (SARs)

A

Employee compensation based on increases in stock price

  • Advantages:
    • Motivates employees
    • Aligns with shareholders’ interests
    • Limited downside risk, but unlimited upside potential, like stock options
    • Shareholder ownership is not diluted
  • Disadvantages:
    • Requires current period cash outflows
34
Q

Phantom stock

A

Differ from SARs in that compensation is based on hypothetical stock, e.g. a business unit within a company that is not publicly traded

35
Q

Remeasurement gain/loss reported within OCI under IFRS

A

Actuarial gains/losses plus the difference between the actual return on plan assets and the interest cost

“The return implied in the interest expense is 0.06 x opening plan assets = 0.06 x 41,105 = 2,466. This is higher by 66 than the actual return thus creating a loss of 66. The remeasurement loss is 430 + 66 = 496”

36
Q

Amortized cost

(intent to be held-to-maturity)

A

Must meet two criteria:

  • Business model test: Assets held to collect contractual cash flows; and
  • Cash flow test: Contractual cash flows are only amounts of principal and interest
  • If the financial asset meets the criteria above but may be sold (‘Hold-to-collect and sell’), it may be measured as FVOCI, or FVPL (to avoid accounting mismatch).
37
Q

Investment in Financial Asset Methods

A. Cost

FVPL

FVOCI

A
38
Q

Intercorporate Investments: Accounting Method

Which one to use:

<20%
20-50%
>50%

A
39
Q

Receivables Securitization

2 Options

VIE/SPE

A

Fun Times, Inc. owns and operates amusement parks in the U.S. It wants to raise $235m in capital by borrowing against its financial receivables

Fun Times Inc. is considering two options:

Option 1: Borrow directly against the receivables

Option 2: Create a special purpose entity by establishing a new corporation, called FT Europe, Inc. To create the SPE, Fun Times Inc. will invest $15m in the SPE, the SPE will then borrow $235m. The funds will be used to purchase $250m of receivables from Fun Times Inc.

  • !The SPE may be able to borrow the funds at a lower rate than Fun Times Inc. given the SPE is bankruptcy remote from Fun Times Inc., and the lenders to the SPE are the claimants on the purchased receivables*
  • !!!Consolidated balance sheet looks the same as if it had borrowed directly against the receivables (option 1). The sale of accounts receivable is reversed along with any gain recognized on the initial sale!!*
40
Q

Cash conversion cycle

A

CCC = Days in sales + Days in inventory – Days in payables

41
Q

Receivables Turnover

Receivables Days

A

Sales / Acc. Receivables

Receivables Days = 365 / R. Turnover

42
Q

Inventory Turnover

Inventory Days

A

COGS / Average Value of Inventory

Inventory Days = 365 / Inventory Turnover

43
Q

Accounts payable turnover

A

Net Credit Purchases or COGS / Average Account Payable

44
Q

Basel lII

A

international regulatory framework for banks

Three key highlights:

  1. Minimum capital requirements: Minimum % of its risk-weighted assets (RWA) that a bank must fund with equity capital. Ratios related to capital requirements​
  2. Minimum liquidity: Hold enough high-quality liquid assets to cover its liquidity needs in a 30-day stress scenario (liquidity coverage ratio and the net stable funding ratio)
  3. Stable funding: Minimum amount of stable funding relative to the bank’s liquidity needs over a 1-year horizon. Stable funding is assessed on the basis of (1) the tenor of deposits, long-term being considered more stable than short-term, and (2) the type of depositor—those from consumers are considered more stable than those from interbank markets
    ​
45
Q

Pro forma

A

In Financial accounting, pro forma refers to a report of the company’s earnings that excludes unusual or nonrecurring transactions

46
Q

Receivables to Revenue Ratio

A

Accounts Receivable / Sales

Increas in Ratio = Smaller % of Sales collected -> Caused by decrease in customers ability to pay, channel stuffing, fictitious sales etc. -> may indicate low quality earnings

47
Q

Accruals

(Rechnungsabgrenzung)

A
  • Accruals are revenues earned or expenses incurred which impact a company’s net income on the income statement, although cash related to the transaction has not yet changed hands. Accruals also affect the balance sheet, as they involve non-cash assets and liabilities. Accrual accounts include, among many others, accounts payable, accounts receivable, accrued tax liabilities, and accrued interest earned or payable
  • The accruals are made via adjusting journal entries at the end of each accounting period
  • The use of accrual accounts greatly improves the quality of information on financial statements.
48
Q

Distinguishing cash basis from accrual basis accounting

A
  • Accrual based accounting records revenue and expenses in the accounting period they relate to – not on a cash basis
  • Accrual based accounting requires estimation of future receipts and payments and a subjective allocation of past receipts and payments
  • Earnings = Cash flows + Accruals
  • The accrual component of earnings is less persistent than the cash component of earnings
  • A high level of accruals is likely to mean a quicker reversion to the mean for earnings
  • The closer the earnings are to operating cash flow, the higher the earnings quality
  • A high ratio shows that the company’s acrrual basis earnings has a high aggregate accruals component (more management discretion), whiochj implies less persistent / lower quality earnings
49
Q

Negative goodwill

A

Negative goodwill is recognized immediately as a gain in profit or loss = bargain purchase

50
Q

Banks

A
  • Liquidity risk is a major concern for a bank, despite not carrying inventory. A bank’s assets are primarily financial assets (loans), which are often measured at fair value. It is important that a bank have adequate liquidity in its assets such that it could withstand the demand for a redemption of deposits (liabilities) if it arose.
  • Banks generally do have fewer tangible assets than industrials.
51
Q

Risk-weighted asset

A
  • Is a bank’s assets or off-balance-sheet exposures, weighted according to risk
  • The assets are adjusted on the basis of their risks, with higher-risk assets receiving a higher weighting
  • Cash is assigned a weighting of zero; as a result, no capital is required to fund it, whereas risky assets, such as high-volatility commercial real estate loans that are more than 90 days past due, have a weighting of greater than 100%
52
Q

Equities = Assets - Liabilities

A

CFA Level 2 (10 decks)

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