FR&A Flashcards
Categories of intercorporate investments
- Investments in financial assets. An ownership interest of less than 20% is usually considered a passive investment. In this case, the investor cannot significantly influence or control the investee. IFRS and GAAP classify investments in financial assets as held-to-maturity, available-for-sale, or fair value through profit or loss (which includes held-for-trading and securities designated at fair value).
- Investments in associates. An ownership interest between 20% and 50% is typically a noncontrolling investment; however, the investor can usually significantly influence the investee’s business operations. The equity method is used to account for investments in associates.
- Business Combinations. An ownership interest of more than 50% is usually a controlling investment. When the investor can control the investee, the acquisition method is used.
- Joint ventures. A joint venture is an entity whereby control is shared by two or more investors. Both IFRS and U.S. GAAP require the equity method for joint ventures. In rare cases, IFRS and U.S. GAAP allow proportionate consolidation as opposed to the equity method.
Reclassification of Investments in Financial Assets
Impairment of Financial Assets
If the value that can be recovered for a financial asset is less than its carrying value and is expected to remain so, the financial asset is impaired. IFRS and U.S. GAAP require that held-to-maturity (HTM) and available-for-sale (AFS) securities be evaluated for impairment at each reporting period.
- GAAP: A security is considered impaired if its decline in value is determined to be other than temporary. For both HTM and AFS securities, the write-down to fair value is treated as a realized loss (i.e., recognized on the income statement). Reversal of impairment losses is not allowed.
- IFRS: If a held-to-maturity security has become impaired, its carrying value is decreased to the present value of its estimated future cash flows, using the same effective interest rate that was used when the security was purchased. This may not be equal to its fair value. Impairments of available-for-sale debt securities may be reversed as impairments of held-to-maturity securities. Reversals of impairments are not permitted for equity securities.
IFRS 9
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Amortized Cost - for debt securities only, same as the held-to-maturity method. Criteria for amortized cost accounting:
- Business model test: Debt securities are being held to collect contractual cash flows.
- Cash flow characteristic test: The contractual cash flows are either principal or interest on principal, only.
- Fair Value Through Profit or Loss - for debt and equity securities, essentially “held for trading”. Once classified, the choice is irrevocable. Derivatives that are not used for hedging are always carried at FVPL.
- Fair Value Through OCI - For debt and equity securities. Essentially “available for sale”
- Reclassification of equity securities under the new standards is not permitted as the initial designation (FVPL or FVOCI) is irrevocable. Reclassification of debt securities is permitted only if the business model has changed.
- The incurred loss model for loan impairment was replaced by the expected credit loss model. The new criteria results in an earlier recognition of impairment (12-month expected losses for performing loans and lifetime expected losses for nonperforming loans).
Summary of Classifications of Financial Assets
Fair Value Option
U.S. GAAP allows equity method investments to be recorded at fair value. Under IFRS, the fair value option is only available to venture capital firms, mutual funds, and similar entities. The decision to use the fair value option is irrevocable and any changes in value (along with dividends) are recorded in the income statement.
Excess of Purchase Price Over Book Value Acquired
- At the acquisition date, the excess of the purchase price over the proportionate share of the investee’s book value is allocated to the investee’s identifiable assets and liabilities based on their fair values. Any remainder is considered goodwill.
- It is important to note that the purchase price allocation to the investee’s assets and liabilities is included in the investor’s balance sheet, not the investee’s. In addition, the additional expense that results from the assigned amounts is not recognized in the investee’s income statement.
Transactions with the investee
In an upstream sale (investee to the investor) or a downstream sale (investor to the investee), the investee or investor has recognized all of the profit in its income statement and must eliminate the proportionate share of the profit that is unconfirmed. Profit from these transactions must be deferred until the profit is confirmed through use or sale to a third party.
Category of business combinations
- Merger. The 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. Recall that when less than 100% of the subsidiary is owned by the parent, the parent prepares consolidated financial statements but reports the unowned (minority or noncontrolling) interest on its financial statements.
- Consolidation. A new entity is formed that absorbs both of the combining companies.
- The acquisition method i required for business combination.
Full goodwill vs. partial goodwill
- Under U.S. GAAP, goodwill is the amount by which the fair value of the subsidiary is greater than the fair value of the acquired company’s identifiable net assets (full goodwill).
- If the full goodwill method is used, noncontrolling interest is based on the acquired company’s fair value.
- The full goodwill method results in higher total assets and higher total equity than the partial goodwill method. Thus, return on assets and return on equity will be lower if the full goodwill method is used.
- Under IFRS, goodwill is the excess of the purchase price over the fair value of the acquiring company’s proportion of the acquired company’s identifiable net assets (partial goodwill). However, IFRS permits the use of the full goodwill approach also.
- If the partial goodwill method is used, noncontrolling interest is based on the fair value of the acquired company’s identifiable net assets.
Goodwill impairment
- IFRS (single step approach): carrying amount of the unit > recoverable amount, an impairment loss is recognized.
- GAAP (two steps):
- If, carrying value of the unit > fair value of the unit, an impairment exists.
- Loss is measured as the difference between the carrying value of the goodwill and the implied fair value of the goodwill. The loss is recognized in the income statement as a part of continuing operations.
Bargain purchase
In rare cases, acquisition purchase price is less than the fair value of net assets acquired. Both IFRS and U.S. GAAP require that the difference between fair value of net assets and purchase price be recognized as a gain in the income statement.
Accounting for Joint Venture
Both U.S. GAAP and IFRS require the equity method of accounting for joint ventures.
In rare circumstances, the proportionate consolidation method may be allowed under U.S. GAAP and IFRS. Proportionate consolidation is similar to a business acquisition, except the investor (venturer) only reports the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. Since only the proportionate share is reported, no minority owners’ interest is necessary.
Special Purpose and Variable Interest Entities.
- VIE is an entity that has one or both of the following characteristics:
- At-risk equity that is insufficient to finance the entity’s activities without additional financial support.
- Equity investors that lack any one of the following:
- Decision making rights.
- The obligation to absorb expected losses.
- The right to receive expected residual returns.
- If an SPE is considered a VIE, it must be consolidated by the primary beneficiary. The primary beneficiary is the entity that absorbs the majority of the risks or receives the majority of the rewards.
Restructuring Costs
Restructuring costs are expensed when incurred—and not capitalized as part of the acquisition cost—under both IFRS and U.S. GAAP.
In-Process R&D
In-process R&D is capitalized as an intangible asset and included as an asset under both U.S. GAAP and IFRS. In-process R&D is subsequently amortized (if successful) or impaired (if unsuccessful).
Define contribution plan
- A defined contribution plan is a retirement plan whereby the firm contributes a certain sum each period to the employee’s retirement account.
- The firm makes no promise to the employee regarding the future value of the plan assets. The investment decisions are left to the employee, who assumes all of the investment risk.
- Pension expense is simply equal to the employer’s contribution. There is no future obligation to report on the balance sheet.
Defined-benefit plan
- 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 compensation at, or near, retirement.
- Since the employee’s future benefit is defined, the employer assumes the investment risk.
- The difference in the benefit obligation and the plan assets is referred to as the funded status of the plan.
Funded status of the plan
- If the plan assets exceed the pension obligation, the plan is said to be “overfunded.”
- if the pension obligation exceeds the plan assets, the plan is “underfunded.”
Other post-employment benefit plan
Pension plans are typically funded at some level, while other post-employment benefit plans are usually unfunded. In the case of an unfunded plan, the employer recognizes expense in the income statement as the benefits are earned; however, the employer’s cash flow is not affected until the benefits are actually paid to the employee.
Projected Benefit Obligation (PBO)
[known as present value of defined benefit obligation (PVDBO) under IFRS
Actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases. It measures the value of the obligation, assuming the firm is a going concern and that the employees will continue to work for the firm until they retire.
PBO changes as a result of
- Current service cost is the present value of benefits earned by the employees during the current period. It includes an estimate of compensation growth (future salary increases)
- Interest cost is the increase in the obligation due to the passage of time.
- Past (prior) service costs are retroactive benefits awarded to employees when a plan is initiated or amended.
- Changes in actuarial assumptions are the gains and losses that result from changes in variables such as mortality, employee turnover, retirement age, and the discount rate. An actuarial gain will decrease the benefit obligation and an actuarial loss will increase the obligation.
- Benefits paid reduce the PBO.
Past (prior service cost)
- Retroactive benefits awarded to employees when a plan is initiated or amended.
- Under IFRS, past service costs are expensed immediately.
- Under U.S. GAAP, past service costs are amortized over the average service life of employees.
Funded status of a pension plan
Total periodic pension cost (TPPC)
Total periodic pension cost (TPPC)
= employer contributions − (ending funded status − beginning funded status)
= current service cost + interest cost − actual return on plan assets +/– actuarial losses/gains due to changes in assumptions affecting PBO + prior service cost
= periodic pension cost in P&L + periodic pension cost in OCI
Periodic Pension Cost Reported in P&L
Under IFRS, the expected rate of return on plan assets is implicitly assumed to be the same as the discount rate used for computation of PBO and a net interest expense/income is reported as discussed above.
Actuarial gains and losses
We defined actuarial gains/losses as changes in PBO due to changes in actuarial assumptions:
- The first component is the gain (loss) due to decrease (increase) in PBO occurring on account of changes in actuarial assumptions;
- The second component is the difference between actual and expected return on plan assets.
Actuarial gains and losses are recognized in other comprehensive income (OCI). Under IFRS, actuarial gains and losses are not amortized. Under U.S. GAAP, actuarial gains and losses are amortized using the corridor approach.
Corridor Approach (U.S. GAAP only)
For any period, once the beginning balance of actuarial gains and losses exceed 10% of the greater of the beginning PBO or plan assets, amortization is required. This arbitrary 10% “corridor” represents a materiality threshold whereby gains and losses should offset over time. The excess amount over the “corridor” is amortized as a component of periodic pension cost in P&L over the remaining service life of the employees.
Reported pension expense vs. TPPC
Reported pension expense:
- is what we report in the income statement.
- uses EXPECTED return on plan assets.
- is computed differently depending on whether we’re using IFRS or US GAAP.
Total periodic pension cost (TPPC):
- is the true (i.e., economic) cost of the pension plan.
- does not change depending on the accounting system chosen.
- uses ACTUAL return on plan assets.
Three Assumptions in pension calculations
- Discount rate
- Rate of compensation growth
- Expected return on plan assets (Assumed only under GAAP; under IFRS, always equal to discount rate)
Effect of Changing Pension Assumptions
- Increasing discount rate
- Reduce PV, hence, PBO is lower
- Reduce interest cost, unless the plan is mature
- lower TPPC
- Reducing compensation growth rate
- Reduce future benefit payments, hence, PBO is lower
- Reduce current service cost and interest cost, thus TPPC is lower
- Increasing expected return on plan assets (only under GAAP not IFRS)
- Reduce periodic pension cost reported in P&L
- Not affect the benefit obligation
Analysts adjustments to pensions treatments
- Gross vs. net pension assets/liabilities
- 2 reason for netting pension assets/liabilities
- The employer largely controls the plan assets and the obligation and, therefore, bears the risks and potential rewards.
- The company’s decisions regarding funding and accounting for the pension plan are more likely to be affected by the net pension obligation, not the gross amounts, because the plan assets can only be used for paying pension benefits to its employees.
- 2 reason for netting pension assets/liabilities
- Different assumptions used
- Differences between IFRS and GAAP
- Differences due to classification in the income statement
- GAAP: the entire periodic pension cost in P&L (including interest) is shown as an operating expense
- IFRS: the components of periodic pension cost can be included in various line items.
- Analyst can adjust GAAP reported income by:
- Adding back the periodic pension cost in P&L and subtracting only service cost in determining operating income.
- Interest cost should be added to the firm’s interest expense
- Actual return on plan assets should be added to nonoperating income.
- This adjustment excludes (ignores) any amortizations
Adjust pension contribution in cash-flow
If the difference between cash flow and total periodic pension cost is material, the analyst should consider reclassifying the difference from operating activities to financing activities in the cash flow statement.
Accounting for stock option
- The compensation expense is allocated in the income statement over the service period, which is the time between the grant date and the vesting date.
- Decrease net income and retained earning. Increase paid-in capital.
- Results in no change to total equity.
6 inputs of Option-pricing models
- Exercise price
- Stock price at the grant date
- Expected term
- Expected volatility
- Expected dividends
- Risk-free rate.
Stock appreciation rights
- A stock appreciation award gives the employee the right to receive compensation based on the increase in the price of the firm’s stock over a predetermined amount.
- Employees have limited downside risk and unlimited upside potential, thereby limiting the risk aversion problem discussed earlier.
- No dilution to existing shareholders.
- Require current period cash outlay.
Didfferent currencies involved in multinational accounting
- The local currency is the currency of the country being referred to.
- The functional currency, determined by management, is the currency of the primary economic environment in which the entity operates.
- The presentation (reporting) currency is the currency in which the parent company prepares its financial statements.
Foreign currency transaction exposure
- Foreign currency denominated transactions, including sales, are measured in the presentation (reporting) currency at the spot rate on the transaction date. Foreign currency risk arises when the transaction date and the payment date differ.
- If the balance sheet date occurs before the transaction is settled, gains and losses on foreign currency transactions are recognized.
- Both IFRS and GAAP require transaction gains and losses to be included in the income statement. However, neither standard requires disclosure of where such gains/losses would be recorded.
Two methods used to translate the financial statements of a foreign subsidiary to the reporting currency
- Remeasurement involves converting the local currency into functional currency using the temporal method. Remeasurement usually occurs when a subsidiary is well integrated with the parent
- Translation involves converting the functional currency into the parent’s presentation (reporting) currency using the current rate method. The current rate method is also known as the all-current method. Translation usually involves self-contained, independent subsidiaries whose operating, investing, and financing activities are decentralized from the parent.
- In the case where the local currency, the functional currency, and the presentation currency all differ, both the temporal method and the current rate method are used.
Define exchange rates
- The current rate is the exchange rate on the balance sheet date.
- The average rate is the average exchange rate over the reporting period.
- The historical rate is the actual rate that was in effect when the original transaction occurred.
Step of calculating translation gain/loss
Inventory and Cost of Goods Sold (Temporal)
- Inventory (Historic Rate):
- FIFO = ending inventory translated at relatively recent rates
- LIFO = ending inventory converted at older rates
- AVCO = ending inventory converted at average exchange rate
- Cost of Goods Sold:
- FIFO/LIFO at weighted historic rate when the items assumed to have been sold during the year were acquired
- AVCO at weighted average exchange rate.
Impact of changing exchange rates on exposure
Summary of Temporal Method and Current Rate Method
Pure Rate and Mixed Rate
- Pure balance sheet and pure income statement ratios will be the same.
- If the foreign currency is depreciating, translated mixed ratios (with an income statement item in the numerator and an end-of-period balance sheet item in the denominator) will be larger than the original ratio.
- If the foreign currency is appreciating, translated mixed ratios (with an income statement item in the numerator and an end-of-period balance sheet item in the denominator) will be smaller than the original ratio.
- We can’t make any definitive statements about whether specific ratios will be larger or smaller after translation unless we make the assumption that all mixed ratios are calculated using end-of-period balance sheet figures.
Analyzing the effect on the financial ratios
- Determine whether the foreign currency is appreciating or depreciating.
- Determine which rate is used to convert the numerator under both methods. Determine whether the numerator of the ratio will be the same, larger, or smaller under the temporal method versus the current rate method.
- Determine which rate is used to convert the denominator under both methods. Determine whether the denominator of the ratio will be the same, larger, or smaller under the temporal method versus the current rate method.
- Determine whether the ratio will increase, decrease, or stay the same based on the direction of change in the numerator and the denominator.
Impact of hyperinflationary environment
- A hyperinflationary environment is one where cumulative inflation exceeds 100% over a 3-year period
- In a hyperinflationary environment, the local currency will rapidly depreciate relative to the reporting currency because of a deterioration of purchasing power. Using the current rate to translate all of the balance sheet accounts will result in much lower assets and liabilities after translation.
- Accounting treatment:
- GAAP: the functional currency is considered to be the parent’s presentation currency; thus, the temporal method is used.
- IFRS: the foreign currency financial statements are restated for inflation and then translated using the current exchange rate.
IFRS restating inflation for hyperinflation environment
- Nonmonetary assets and nonmonetary liabilities are restated for inflation using a price index.
- It is not necessary to restate monetary assets and monetary liabilities.
- The components of shareholders’ equity (other than retained earnings) are restated by applying the change in the price index from the beginning of the period or the date of contribution if later.
- R/E is the plug figure that balances the balance sheet.
- In the statement of retained earnings, net income is the plug figure.
- The income statement items are restated by multiplying by the change in the price index from the date the transactions occur.
- The net purchasing power gain or loss is recognized in the income statement based on the net monetary asset or liability exposure.
- Holding monetary assets during inflation results in a purchasing power loss.
- Holding monetary liabilities during inflation results in a purchasing power gain.
Similarities of Temporal Method and Inflation Adjusted F/S
Changes in effective tax rate on account of foreign operations can be due to:
- Changes in the mix of profits from different countries (with varying tax rates).
- Changes in the tax rates.
Effective tax rate
Tax expense in the income statement divided by pretax profit.
Statutory tax rate
Statutory tax rate is provided by the tax code of the home country.
Organic growth
Organic growth in sales is defined as growth in sales excluding the effects of acquisitions/divestitures and currency effects.
Global Organizations that coordinate regulations
- Financial Stability Board, which seeks to coordinate actions of participating jurisdictions in identifying and managing systemic risks.
- International Association of Deposit Insurers, which seeks to improve the effectiveness of deposit insurance systems.
- International Organization of Securities Commissions (IOSCO), which seeks to promote fair and efficient security markets.
- International Association of Insurance Supervisors (IAIS), which seeks to improve supervision of the insurance industry.
Contagion Effect
As an intermediary between providers and users of capital, there are often inter-linkages between financial institutions. These inter-dependencies introduce a system-wide risk of failure when one of the member institutions fails
Financial institutions differ from other companies as follow
- Systemic importance: Financial institutions are necessary for the smooth functioning and overall health of the economy. To avoid financial contagion, bank deposits are often insured up to a certain limit by the government.
- Highly regulated
- Assets: The assets of financial institutions tend to be financial assets such as loans and securities that are usually reported at fair value.
Three pillars of the Basel III framework
The three pillars of the Basel III framework are the maintenance of minimum levels of capital, liquidity, and stable funding:
- Minimum required capital for a bank is based on the risk of the bank’s assets. The riskier a bank’s assets are, the higher its required capital.
- Basel III specifies that a bank should hold enough liquid assets to meet demands under a 30-day liquidity stress scenario.
- The Basel III framework requires stable funding relative to a bank’s liquidity needs over a one-year time horizon.
Objective of Base III Framework
Increasing the banking sector’s ability to absorb economic and financial shocks.
CAMELS Approach
- Capital Adequacy
- Asset Quality
- Management quality
- Earnings quality
- Liquidity
Capital Adequacy
- Based on risk-weighted assets (RWA); more risky assets require a higher level of capital.
- Total capital is composed of Tier 1 capital (which includes Common Equity Tier 1 and other Tier 1 capital) and Tier 2 capital.
- Common Equity Tier 1 capital (the most important component): Common stock, additional paid-in capital, retained earnings, and OCI less intangibles and deferred tax assets.
- Other Tier 1 capital: subordinated instruments with no specified maturity and no contractual dividends (e.g., preferred stock with discretionary dividends).
- Subordinated instruments with original (i.e., when issued) maturity of more than five years.
- Basel III specifies minimums for Common Equity:
- Tier 1 capital of 4.5% of RWA
- Total Tier 1 capital of 6% of RWA, and
- Total capital of 9% of RWA.
Asset Quality
Bank assets include loans (the largest component) and investments in securities. Asset quality derives from the processes of generating assets, managing them, and controlling overall risk. Evaluation of asset quality includes analysis of current and potential credit risk associated with the bank’s assets.
Reverse Repurchase Agreement
Reverse repurchase agreements are bank loans advanced under a repurchase agreement (i.e., against a high-quality collateral).
Asset held for sale
Assets held for sale pertain to discontinued operations whose value in the balance sheet assumes disposition (as opposed to long-term holding).
Allowance for loan losses
Allowance for loan losses is a contra asset account to loans and is the result of provision for loan losses, an expense subject to management discretion.
Ratios useful in evaluating loan loss provisions
- Ratio of allowance for loan losses to nonperforming loans.
- Ratio of allowance for loan losses to net loan charge-offs.
- Ratio of provision for loan losses to net loan charge-offs.
High quality earnings
- Adequate (providing a rate of return above the cost of capital) as well as sustainable.
- The trend in earnings should be positive and the underlying accounting estimates should be unbiased.
- Earnings should ideally be derived from recurring sources.
Fair value hierarchy
- Level 1 inputs are quoted market prices of identical assets.
- Level 2 inputs are observable but not quoted prices of identical assets.
- Level 3 inputs are non-observable and hence subjective.
Major sources of earnings for a typical bank
- Net interest income
- Service income
- Trading income (most volatile year-to-year
On a relative basis, banks with proportionally higher net interest income and service income would have more sustainable earnings.
Liquidity Position *LCR”
LCR = highly liquid assets / expected cash outflows
- Highly liquid assets are those that are easily convertible into cash
- Expected cash flows are the estimated one-month liquidity needs in a stress scenario.
- The standards recommend a minimum LCR of 100%.
Net stable funding ratio (NSFR)
NSFR = available stable funding / required stable funding
- Available stable funding is a function of the composition and maturity distribution of a bank’s funding sources. Available stable funding (ASF) is determined based on an ASF factor that is assigned to each funding source.
- Required stable funding is a function of the composition and maturity distribution of the bank’s asset base.
- NSFR relates the liquidity needs of a bank’s assets to the liquidity provided by the bank’s liabilities (i.e., funding sources).
- Longer-dated liabilities are considered more stable and hence would be suitable to fund assets with longer maturities (e.g., long-term loans).
- The standards recommend a minimum NSFR of 100%.
Concentration of funding and maturity mismatch
- Liquidity monitoring metrics recommended by Basel III.
- Relatively concentrated funding may pose a problem when the sources withdraw funding, resulting in heightened liquidity risk
- Maturity mismatch occurs when the asset maturities differ meaningfully from maturity of the liabilities (funding sources).
- The higher the mismatch, the higher the liquidity risk for the bank.
Interest rate sensitivity factors
- Maturity
- Repricing frequency
- Reference rates
- Shaping risk
Other factors analysts should consider when analyzing banks
- Government Support
- Larger banks enjoy a higher probability of implicit government support.
- The implicit support level is inversely related to the overall health of the banking sector; during good times, support levels are low.
- Government Ownership
- Bank mission
- Culture: propensity to seek risky investments
- Diversity of a bank’s assets
- Accounting restatements due to failures of internal controls pertaining to financial reporting
- Management compensation
- Speed with which a bank adjusts its loan loss provisions relative to actual loss behavior
- Competitive environment
- Off-balance-sheet assets and/or liabilities
- Segment information
- Currency exposure
Typer of insurers
- Property and Causality Insurers (P&C): Provide protection against adverse events related to homes, cars, and commercial activities (Liability insurance). Typically short-term and claims are lumpier based on unpredictable events
- Life and Health Insurers (L&H): provide mortality and health-related insurance products; also offer savings products. Typically longer term and claims are predictable based on actuarial mortality rates.
- Reinsurance: insure insurers, reimburse insurance companies for claims paid; global business = systemic risk.
Insurance company revenues
- Premium income
- income on float (premiums not yet paid out in claims)
Keys to P&C Insurer profitability
- Prudence in underwriting
- Pricing of premiums
- Soft pricing period: During periods of heightened competition, price cutting to obtain new business leads to slim or negative margins
- Hard pricing period: Reduction in competition leads to a healthier pricing environment, which in turn results in fatter margins
- Diversification of risk
- Reinsurance
Direct writer vs indirect writers
- Direct writer: own sales and marketing staff - higher fixed costs
- Agency writer: use agents and insurance brokers - higher variable costs
Soft/Hard Pricing
- Soft/Hard pricing derived from combined ratio
- Soft/hard pricing = (Total incurred losses + expenses) / Net premium earned
- High = soft market
- Low = hard market
Combined ratio
- Combined ratio is the sum of underwriting loss ratio and expense ratio
- Combined ratio measures quality of underwriting activities and the efficiency of operations
- IFRS: underwriting loss ration and expense ration have different denominators
- GAAP: uses net premium earned for both ratios
Dividend to policyholders ratio
= Dividends to policyholders / net premium earned
Combined ratio after dividends (CRAD)
= combined ration - dividends to policyholders ratio
Loss and loss adjustment expense ration
= (loss expense + loss adjustment expense) / net premiums earned
Primary considerations in analysis of L&H insurers
- Revenue diversification
- Earnings characteristics (Industry-specific cost ratios)
- total benefits paid / net premiums written and deposits
- commissions and expenses / net premiums written and deposits
- Investment returns
- Liquidity
- Capitalization
Two highly related dimensions of quality of financial reports
- Earning quality (Results quality)
- High level of earnings
- Sustainability of earnings
- Reporting quality
Steps in evaluating the quality of financial reports:
Step 1: Understand the company, its industry, and the accounting principles it uses and why such principles are appropriate.
Step 2: Understand management including the terms of their compensation. Also evaluate any insider trades and related party transactions.
Step 3: Identify material areas of accounting that are vulnerable to subjectivity.
Step 4: Make cross-sectional and time series comparisons of financial statements and important ratios.
Step 5: Check for warning signs as discussed previously.
Step 6: For firms in multiple lines of business or for multinational firms, check for shifting of profits or revenues to a specific part of the business that the firm wants to highlight. This is particularly a concern when a specific segment shows dramatic improvement while the consolidated financials show negative or zero growth.
Step 7: Use quantitative tools to evaluate the likelihood of misreporting.
Beneish Model
M-score = –4.84 + 0.920 (DSRI) + 0.528 (GMI) + 0.404 (AQI) + 0.892 (SGI) + 0.115 (DEPI) − 0.172 (SGAI) + 4.679 (Accruals) − 0.327 (LEVI)
where:
M-score > –1.78 (i.e., less negative) indicates a higher-than-acceptable probability of earnings manipulation.
Days sales receivable index (DSRI): Ratio of days’ sales receivables in year t relative to year t − 1. A large increase in DSRI could be indicative of revenue inflation.
Gross margin index (GMI): Ratio of gross margin in year t − 1 to that in year t. When this ratio is greater than 1, the gross margin has deteriorated. A firm with declining margins is more likely to manipulate earnings.
Asset quality index (AQI): Ratio of non-current assets other than plant, property, and equipment to total assets in year t relative to year t − 1. Increases in AQI could indicate excessive capitalization of expenses.
Sales growth index (SGI): Ratio of sales in year t relative to year t − 1. While not a measure of manipulation by itself, growth companies tend to find themselves under pressure to manipulate earnings to meet ongoing expectations.
Depreciation index (DEPI): Ratio of depreciation rate in year t − 1 to the corresponding rate in year t. The depreciation rate is depreciation expense divided by depreciation plus PPE. A DEPI greater than 1 suggests that assets are being depreciated at a slower rate in order to manipulate earnings.
Sales, general and administrative expenses index (SGAI): Ratio of SGA expenses (as a % of sales) in year t relative to year t − 1. Increases in SGA expenses might predispose companies to manipulate.
Accruals = (income before extraordinary items − cash flow from operations) / total assets.
Leverage index (LEVI): Ratio of total debt to total assets in year t relative to year t − 1.
Limitation of Beneish Model
- Accounting data may not reflect economic reality
- As managers become aware of the use of specific quantitative tools, they may begin to game the measures used
Altman Model
- Developed to assess the probability that a firm will file for bankruptcy.
- Relies on discriminant analysis to generate a Z-score using five variables:
- net working capital as a proportion of total assets,
- retained earnings as a proportion of total assets,
- operating profit as a proportion of total assets,
- market value of equity relative to book value of liabilities,
- sales relative to total assets.
- Each variable is positively related to the Z-score
- A higher Z-score is better (less likelihood of bankruptcy).
Steps in the analysis of revenue recognition practice
- Understand the basics
- Evaluate and question aging receivables
- Cash versus accruals
- Compare financials with physical data provided by the company
- Evaluate revenue trends and compare with peers
- Check for related party transactions.
Framework for Analysis
- Establish the objectives
- Collect data
- Process data
- Analyze data
- Develop and communicate conclusions
- Follow up
Accruals Ratio and Earning Qualities
- The ratio of accruals to average net operating assets can be used to measure earnings quality.
- The lower the ratio, the higher the earnings quality.
Earnings quality
Earnings quality refers to the persistence and sustainability of a firm’s earnings.
Net Operating Asset (NOA)
= Operating Asset - Operating Liabilities
= (Total Asset – Cash & Cash Equivalents) - (Total Liabilities – Total debt)
2 approaches to measure accruals
- Balance sheet approach: Accruals RatioBS = NOAEND - NOABEG
- Cash flow approach: Accruals RatioCF = NI - CFO - CFI
Accruals Ratio
= Accrual Measure / [(NOAEND + NOABEG)/2]
Cash generated from operations (CGO)
CGO = EBIT + non-cash charges − increase in working capital
=CFO + Cash interest paid + Cash taxes paid
