Reading 17 Analysis of Financial Institutions

Question 1

Difference between Fis and Normal Entities

Answer 1

Systemic Risk

Regulated : Domestic Regulators and Basel

Assets : Financial Assets at Fair value.

Basel holds that Systemic risk is not limited to a country and can spread across

When one of the member institutions fails—the contagion effect.

Deposits are insured to protect against bank runs,

Question 2

Problem - Solve Only HTM

Answer 2

Solution HTM

Question 3

Problem Solve only HTT

Answer 3

Solution Only HTT

Question 4

Problem - Solve only AFS

Answer 4

Solution - only AFS

Question 5

Bright Line Criteria

Answer 5

Any kind of classification for intercorporate investment is based on INFLUENCE & CONTROL

Percentage Ownership / Bright line Criteria is used as under

Financial Assets / Passive = less than 20% holdings - DEBT ONLY

Investment in Associates / Influence = Between 20% to 50% holdings - EQUITY INVESTMENT ONLY

Business Combinations / Control = greater than 50% holdings

There is one more way: Shared Control = Joint Venture. A Joint Venture also uses Equity Method

Question 6

Held to Maturity

Answer 6

Only for Debt securities where the company has intent and ability to hold to maturityProfit & Loss Statement

Interest income earned on the bonds is reported in the P/L. This interest Income is based on YTM of the bond computed at the time of purchase of the Bond. Interest Income Formula = Coupon + Amortized Discount - Amortized Premium

Balance SheetCarried on the Balance Sheet at Amortized Cost. Changes in Mkt value not recognized unless impaired. Panelized by disallowing future Held to Maturity if the Bond is sold earlier or Reclassified, Reported at

Cost includes transaction Costs (US GAAP) and

Fair Value including transaction costs (IFRS)

Question 7

Held for Trading (US GAAP) / Fair Value through Profit & Loss (IFRS)

Answer 7

Used for Debt and Equity securities for the purpose of selling in near future.

Profit & Loss Statement

Interest & Dividend Income reported to Income Statement. Interest Income formula = Coupon + Amortized Discount - Amortized Premium (Same as HTM)

Unrealized Gains and Losses (Computed on yearend) reported under P&L

Balance Sheet

Carried on Balance Sheet at Fair Value

Question 8

Available for Sale Securities

Answer 8

Used for Debt and Equity Securities for the purpose of selling in medium term.

Profit & Loss Statement

Interest & Dividend Income reported on Income Statement. Interest Income Formula = Coupon + Amortized Discount - Amortized Premium (same as HTM & HTT).

Unrealized Gains and Losses reported indirectly in EQUITY and reported through Other Comprehensive Income (OCI)

When Sold realized gains and losses are recognized in P&L

Balance Sheet

Carried on Balance Sheet at Fair Value

Question 9

Designated at Fair Value

Answer 9

Companies have an option and the company can choose to report all investments as HTT. Treated like HTT.

Question 10

FX Gains & Sale in Financial Assets

Answer 10

There are two sources ofgains in case of a bond. 1) gain in mkt price of the bond 2) FX gains in case the bond is denominated in a foreign currency. Under IFRS and in Available for Sale Classification the FX portion of the gains is reported to the Income Statement. Whereas under GAAP this goes through OCI

Whenever the interest income is greater than the coupon then it is a discount bond.

Question 11

IFRS 9 New Standards

Answer 11

Amortized Cost (Debt Securities Only) = HTM

Two Additional Test

Business Model Test - How the asset is managed) - Values intent whether the company intends to hold it till maturity

Cash Flow Characteristics - Payments are solely interst and pricipal. - for hybrid securites that may look like debt securities. The cash flow characteristics ensures that the security to be classified as Amortized cost is a debt security

Fair Value Through Profit and Loss = HTT

Fair Value through OCI - AFS

Question 12

Reclassification under IFRS 9

Answer 12

No reclassification for Equity Securities

Reclassification of Debt securities is allowed only if business model has changed.

Question 13

Investment in Associates and Joint Ventures (Equity Method)

Answer 13

Greater than 20% but less than 50% shareholding (Bright Line Criteria) - includes Joint Ventures - Significant Influence.

Balance Sheet: Reported at Cost + % Earnings - % Dividends- Additional Depreciation

Additional Depreciation = (% Share * Change Between Balance Sheet and Fair Market Value in PPE) / No of Years

Income Statement: % Earnings

Goodwill (Not Disclosed on BS) = Purchase Price - % Share* Fair Market Value + % Share * Change in PPE between Balance Sheet and Fair Market Value

Here Goodwill is Partial Goodwill

Balance Sheet Investment Formula

(% Share in Co x Earnings) - (%Share in Co x Div)

% Share in Co X (Earnings - Dividends)

% Share in Co X Change in Retained Earnings

Question 14

Answer 14

Question 15

Transactions with Associates

Answer 15

Inter-company Transfers

Upstream profits on transactions in associates accounts

Downstream Profits on transactions in Parents Accounts

Investor Company can influence amount and timing

Pro-rata Share of profits not confirmed through resale or use are eliminated from equity income.

Question 16

Analyst Issues

Answer 16

Is it appropriate to use Equity Method

For BS: may obscure liab and undestate leverage

For I/S

only share of NI is shown

Earnings may not be distributed as dividends - lower earning quality.

Question 17

Business Combinations - Acquisition Method

Answer 17

Eliminate Investment Account

Create Minority Interest Account

Calculate Goodwill

Combine all Assets and Liab

Income Statement

Eliminate Subsidiary Earnings

Substract Minority share of earnings

Combine Revenues and Expenses

Question 18

Partial Vs Full Goodwill

Answer 18

Partial Vs Full Goodwill is applicable only under Acquisition Method and the option is only to be considered under IFRS.

US GAAP only allows Full Goodwill.

Partial Goodwill

Goodwill = Purchase Price - % Share* FMV of Equity

GW is allocated to Cash Generating Units

Minority Interest = (1-%Share) * FMV of Equity

Full Goodwill

Full Goodwill = FMV of Subsidiary - FMV of Assets

GW is allocated to the reporting units that will benefit from Synergies

Minority Interst = (1-%Share)*FMV of Subsidiary

Question 19

Impairment of Goodwill

Answer 19

GW is not Amortized but tested for Impairment Annually

GW Impairments cannot be reversed

Allocation

IFRS - Across all cash generating units

USGAAP - Across Reporting Units.

Process

IFRS - One Step Process. If recoverable amount of cash generating unit < Carrying value - recognize difference as impairment

USGAAP - Two Step Process

IF Fair Value of Unit < Carrying Value, Goodwill is impaired

Amount of Impairment : Recalculate goodwill

Loss is greater than Goodwill.

IFRS - Remainder is allocated propotionally to other assets

USGAAP - Goodwill is reduced to zero.

Under Both process, Impairment is reported in the Income statement as a one line item.

Question 20

Comparison of Equity Vs Acquisition Method

Answer 20

Question 21

Problem 2

Answer 21

Question 22

Problem 3

Answer 22

Question 23

Problem 4

Answer 23

Question 24

Problem 5

Answer 24

Question 25

Problem 6

Answer 25

Question 26

Problem 7

Answer 26

Question 27

Problem 8

Answer 27

Question 28

Problem 9

Answer 28