Financial Statement Analysis Flashcards
Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities.
Investments in financial assets: Dividends and interest income are recognized in the investor’s income statement. Amortized cost securities are reported on the balance sheet at amortized cost. Subsequent changes in fair value are ignored. Fair value through profit or loss securities are reported at fair value, and the unrealized gains and losses are recognized in the income statement. Fair value through OCI securities are also reported at fair value, but the unrealized gains and losses are reported in stockholders’ equity.
Investments in associates/joint ventures: With the equity method, the proportionate share of the investee’s earnings increase the investor’s investment account on the balance sheet and are recognized in the investor’s income statement. Dividends received reduce the investment account. Dividends received are not recognized in the investor’s income statement under the equity method. In rare cases, proportionate consolidation may be allowed. Proportionate consolidation is similar to a business combination, except the investor only includes the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. No minority owners’ interest is required.
Business combinations: In an acquisition, all of the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent. Intercompany transactions are excluded. When the parent owns less than 100% of the subsidiary, it is necessary to create a noncontrolling interest account for the proportionate share of the subsidiary’s net assets and net income that is not owned by the parent.
Under IFRS, the sponsor of a special purpose entity (SPE) must consolidate the SPE if their economic relationship indicates that the sponsor controls the SPE. U.S. GAAP requires that a variable interest entity (VIE) must be consolidated by its primary beneficiary.
Compare and contrast IFRS and US GAAP in their classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities.
Differences between IFRS and U.S. GAAP treatment of intercorporate investments include:
IFRS and U.S. GAAP differ between contingent asset and liability recognition under the acquisition method.
IFRS permits either the partial goodwill or full goodwill method to value goodwill and noncontrolling interest in business combinations. U.S. GAAP requires the full goodwill method.
Analyze how different methods used to account for intercorporate investments affect financial statements and ratios.
The effects of the equity method versus the acquisition method:
- Both report the same net income.
- Acquisition method equity will be higher by the amount of minority interest.
- Assets and liabilities are higher under the acquisition method.
- Sales are higher under the acquisition method.
Describe the types of post-employment benefit plans and implications for financial reports.
In a defined-contribution plan, the firm contributes a certain amount each period to the employee’s retirement account. The firm makes no promise regarding the future value of the plan assets; thus, the employee assumes all of the investment risk. Accounting is straight-forward; pension expense is equal to the firm’s contribution.
In a defined-benefit plan, the firm promises to make periodic payments to the employee after retirement. The benefit is usually based on the employee’s years of service and the employee’s salary at, or near, retirement. Since the employee’s future benefit is defined, the employer assumes the investment risk. Accounting is complicated because many assumptions are involved.
Explain and calculate measures of a defined benefit pension obligation (i.e., present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset).
The projected benefit obligation (PBO) is the actuarial present value of future pension benefits earned to date, based on expected future salary increases.
balance sheet asset (liability) = fair value of plan assets − PBO
Describe the components of a company’s defined benefit pension costs.
Components of periodic pension cost reported in P&L:
Current service cost: the present value of benefits earned by the employees during the current period. Expensed in income statement.
Interest cost: the increase in the PBO due to the passage of time. Expensed in income statement. Interest cost (U.S. GAAP) = discount rate × [beg PBO + past service cost]
Net interest cost (IFRS) = discount rate × (beginning funded status – prior service cost)
Expected return on plan assets: offsets reported pension cost. Under U.S. GAAP, the expected rate of return is assumed. Under IFRS, the expected rate of return is the same as the discount rate.
Amortization of actuarial gains and losses: under U.S. GAAP only, the losses (or gains) during the year due to changes in actuarial assumptions and due to differences between expected and actual return are recognized in OCI and amortized using the corridor method. Under IFRS, the actuarial gains and losses during the year are recognized in OCI and are not amortized.
Amortization of past service cost:under U.S. GAAP only, an increase in PBO resulting from plan amendments granting a retroactive increase in benefits is amortized. Under IFRS, past service costs are immediately expensed in the income statement.
Total periodic pension cost includes costs reflected in the income statement (discussed previously) as well as in OCI.
total periodic pension cost = contributions − change in funded status
or
total periodic pension cost = current service cost + interest cost − actual return on plan assets +/− actuarial losses/gains due to changes in assumptions affecting PBO + prior service cost
Explain and calculate the effect of a defined benefit plan’s assumptions on the defined benefit obligation and periodic pension cost.
Firms can improve reported results by increasing the discount rate, lowering the compensation growth rate, or, in the case of U.S. GAAP, increasing the expected return on plan assets.
Explain and calculate how adjusting for items of pension and other post-employment benefits that are reported in the notes to the financial statements affects financial statements and ratios.
Comparative financial analysis using published financial statements is complicated by differences in accounting treatment for pensions:
- Gross vs. net pension assets/liabilities.
- Differences in assumptions used.
- Differences between IFRS and U.S. GAAP in recognizing periodic pension cost in the income statement.
- Differences due to classification in the income statement.
Interpret pension plan note disclosures including cash flow related information.
If the firm’s contributions exceed the total periodic pension cost, the difference can be viewed as a reduction in the overall pension obligation, similar to an excess principal payment on a loan. Conversely, if the total periodic pension cost exceeds the firm’s contributions, the difference can be viewed as a source of borrowing.
If the differences in cash flow and total periodic pension cost are material, the analyst should consider reclassifying the difference from operating activities to financing activities in the cash flow statement.
Explain issues associated with accounting for share-based compensation.
Share-based compensation raises issues about the valuation of the specific compensation as well as about the period in which, or periods over which, the compensation expense should be recorded.
Explain how accounting for stock grants and stock options affects financial statements, and the importance of companies’ assumptions in valuing these grants and options.
Share-based compensation expense is based on the fair value of the option or stock at the grant date. To determine fair value, it is often necessary to use imperfect pricing models.
Many of the option pricing model inputs require subjective estimates that can significantly affect the fair value of the option and, ultimately, compensation expense. For example, lower volatility, a shorter term or a lower risk-free rate, will usually decrease the estimated fair value and compensation expense. A higher expected dividend yield will also decrease the estimated fair value and compensation expense.
Compare and contrast presentation in (reporting) currency, functional currency, and local currency.
The local currency is the currency of the country to which it refers.
The functional currency, determined by management, is the currency of the primary economic environment in which the entity operates. The functional currency is usually the currency in which the entity generates and expends cash. It can be the local currency or some other currency.
The presentation (reporting) currency is the currency in which the entity prepares its financial statements.
Describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses.
Foreign currency denominated transactions, including sales, are measured in the presentation (reporting) currency at the spot rate on the transaction date. If the exchange rate changes, gain or loss is recognized on the settlement date. If the balance sheet date occurs before the transaction is settled, the gain or loss is based on the exchange rate on the balance sheet date. Once the transaction is settled, additional gain or loss is recognized if the exchange rate changes after the balance sheet date.
The standards do not provide guidance as to where such gains/losses are recognized and, hence, reduce comparability of financial statements.
Analyze how changes in exchange rates affect the translated sales of the subsidiary and parent company.
Revenues are translated at average exchange rate under both the temporal method and under the current rate method.
Compare the current rate method and the temporal method, evaluate how each affects the parent company’s balance sheet and income statement, and determine which method is appropriate in various scenarios.
If the functional currency and the parent’s presentation currency differ, the current rate method is used to translate the subsidiary’s financial statements. This usually occurs when the subsidiary is relatively independent of the parent. Under the current rate method, all assets and liabilities are translated at the current rate; common stock and dividends paid at the historic rate; and revenues and expenses at the average rate. Translation gains and losses are reported in equity in the CTA account. The CTA is a plug figure that makes the accounting equation balance.
If the functional currency is the same as the parent’s presentation currency, the temporal method is used to remeasure the subsidiary’s financial statements. This usually occurs when the subsidiary is well integrated with the parent.
Under the temporal method:
- Monetary assets and liabilities are remeasured at the current rate.
- Nonmonetary assets and liabilities are remeasured at the historical rate.
- Common stock and dividends paid are remeasured at the historical rate.
- COGS, depreciation, and amortization expense are remeasured at the historical rate.
- All other revenues and expenses are remeasured at the average rate.
- Remeasurement gains and losses are reported in the income statement.
Calculate the translation effects and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s presentation currency.
Under the current rate method, exposure is defined as the net asset position (assets – liabilities) of the subsidiary. Under the temporal method, exposure is defined as the net monetary asset or net monetary liability position of the subsidiary. When assets are exposed to a depreciating foreign currency, a loss results. When liabilities are exposed to a depreciating foreign currency, a gain results.
The local currency trends and relationships of pure balance sheet and income statement ratios are preserved under the current rate method. When compared to the local currency mixed ratios will differ after translation.
Analyze how the current rate method and the temporal method affect financial statements and ratios.
In comparing the ratio effects of the temporal method and current rate method, it is necessary to:
- Determine whether the local currency is appreciating or depreciating.
- Determine which rate (historical rate, average rate, or current rate) is used to convert the numerator under both methods and analyze the effects on the ratio.
- Determine which rate (historical rate, average rate, or current rate) is used to convert the denominator under both methods and analyze the effects on the ratio.
- Determine whether the ratio will increase, decrease, or stay the same based on the direction of change in the numerator and the denominator.
Analyze how alternative translation methods for subsidiaries operating in hyperinflationary economies affect financial statements and ratios.
A hyperinflationary environment is one where cumulative inflation exceeds 100% over a 3-year period (more than 26% annual inflation). Under U.S. GAAP, the temporal method is required when the subsidiary is operating in a hyperinflationary environment. Under IFRS, the foreign currency financial statements are first restated for inflation and then translated using the current exchange rate. Restating for inflation results in recognition of the net purchasing power gain or loss which is based on the net monetary asset or liability of the subsidiary.
