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Reading 16: Intercorporate Investments

Business
Financial Assets Associates Join Ventures
Combinations
Influence Not significant Significant Controlling Shared control
Typical percentage Usually
Usually < 20% Usually > 50% Varies
interest 20% - 50%
Current Financial Classified as:
Reporting  Held-to-maturity
Treatment (prior  Available-for-sale IFRS: Equity
to IFRS 9 taking  Fair value through Equity method or
Consolidation
effect) P&L (held for trading method proportionate
or designated as fair consolidation
value)
 Loans and receivables
New Financial Classified as:
Reporting  Fair value through
Treatment (post P&L
Equity IFRS: Equity
IFRS 9 taking  Fair value through Consolidation
method method
effect) other comprehensive
income
 Amortized cost

I. Investment in Financial Assets


Standard IAS 39

HTM investments:

 HTM investments cannot be reclassified or sold prior to maturity except in unusual


circumstances.
 Reclassification or sale of HTM investments can result in the investor being precluded from
classifying investments under the HTM category going forward.
 HTM securities are initially recognized at fair value under IFRS and at initial price paid under U.S.
GAAP. Generally speaking, initial fair value equals initial price paid.
 Transaction costs are included in initial fair value for investments that are not classified as fair
value through P&L.
 HTM investments are subsequently reported at amortized cost using the effective interest
method.
o Interest income and realized G/L are recognized in the income statement.
o Unrealized G/L due to changes in fair value are ignored.
o Any difference between the fair value and par value of the security is amortized over its
term.

Fair value through P&L (FVPL):

 Investments classified as FVPL include HFT securities and securities designated at fair value.
 HFT investments are initially recognized at fair value, and subsequently remeasured to reflect
fair value. Realized G/L (upon sales), unrealized G/L (due to changes in fair value), interest
income, and dividend income are all reported in P&L.
 Investments that can be classified as AFS or HTM can also be initially designated at fair value.
The accounting treatment of these designated at fair value investments is similar to that of HFT
investments.

AFS investments:

 AFS investments are debt and equity securities that are not classified as HTM or FVPL.
 AFS investments are initially recognized at fair value, and subsequently remeasured to reflect
fair value.
 All unrealized G/L (except for G/L on AFS debt securities arising from exchange rate movements)
are recognized (net of taxes) in equity under OCI. When they are sold, these G/L are reversed
out of OCI and reported in P/L as a reclassification adjustment.
 Unrealized G/L on AFS debt securities resulting from exchange rate movements are recognized in
P&L.
 Realized G/L, interest income, and dividend income are also recognized in P&L.
 Under U.S. GAAP, all unrealized G/L (including those on AFS debt securities arising from
exchange rate movements) are reported in OCI.

Loans and receivables:

 Loans and receivables are nonderivative financial assets with fixed or determinable payments.
 IFRS has a specific definition (does not rely on legal form). Items that meet the definition are
carried at amortized cost unless they are designated at FVPL or AFS.
 U.S. GAAP relies on legal form. Those that meet the definition of debt securities are classified as
HFT, AFS, or HTM, with HFT and AFS securities being measured at fair value.

Reclassification under IFRS:

 Reclassification of securities into and out of designated at FV is generally prohibited.


 Reclassification out of HFT is restricted.
 HTM securities can be reclassified as AFS securities when there is a change in intention or ability
to hold the asset until maturity.
o They are measured at fair value, and unrealized G/L are recognized in OCI.
o Once a company has reclassified HTM securities, it may be prohibited from using the HTM
classification for other existing debt securities and new purchases.
 AFS securities can be reclassified as HTM securities when there is a change in intention or ability
to hold the asset until maturity.
o Their fair value becomes their new amortized cost, and unrealized G/L previously recognized
in OCI are amortized to P&L.
o Differences between the new amortized cost and par value are also amortized to P&L using
the effective interest method.
 HFT/AFS debt securities can be reclassified as loans and receivables if the definition is met and
the company expects to hold them for the foreseeable future.
 AFS securities can be measured at cost if there is no reliable measure of fair value and no
evidence of impairment.

Reclassification under U.S. GAAP:


 U.S. GAAP generally allows reclassifications when justified.
 If HTM securities are reclassified, the company may be precluded from using the HTM category
for other investments.
 When HFT securities are reclassified as AFS securities, any unrealized G/L have already been
recognized in P&L.
 When securities are reclassified as HFT securities, any unrealized G/L are recognized
immediately in P&L. When AFS securities are reclassified as HFT securities, the cumulative
amount of unrealized G/L previously in OCI is recognized in P&L.
 When HTM securities are reclassified as AFS securities, unrealized G/L are recognized in OCI.
 When AFS debt securities are reclassified as HTM securities, previously unrealized G/L in OCI are
amortized using the effective interest method.

Impairment under IFRS:

 Financial assets not carried at fair value must be assessed at the end of each period, and any
current impairment must be recognized in P&L immediately.
 For securities classified at FVPL, impairment losses have already been recognized in P&L.
 A debt security is considered impaired if at least one loss event (financial difficulty, default, or
delinquency) has occurred. A credit rating downgrade, the absence of an active market, or
future events do not result in impairment losses.
 An equity security is considered impaired if its fair value has declined substantially and
extendedly below its cost, or the investee is adversely affected by changes in the market,
technology, and legal environment.
 Determining impairment losses for HTM securities and loans and receivables:
o Impairment loss is the difference between carrying value and the PV of expected future cash
flows discounted at the initial effective interest rate.
o The carrying amount is reduced either directly or indirectly through an allowance account.
o The impairment loss is recognized in P&L.
o Reversals of impairment losses results in an increase in the carrying value and an increase in
net income.
 Determining impairment losses for AFS securities:
o The cumulative loss in OCI is transferred to P&L as a reclassification adjustment.
o Reversals of impairment losses are only allowed for AFS debt securities (not for AFS equity
securities). The amount of reversal is recognized in P&L.

Impairment under U.S. GAAP:

 AFS and HTM securities must be assessed for impairment at each balance sheet date. A security
is considered impaired if the decline is other than temporary.
 For HTM securities, impairment means the investor is unable to collect all amounts owed
according to contractual terms at acquisition.
o If the decline in fair value is deemed other than temporary, the cost basis is written down to
fair value, which then becomes the new cost basis.
o The impairment loss is recognized in P&L.
 Accounting for impairment losses of AFS debt and securities are the same as HTM securities.
o However, reversals of impairment losses are not allowed.
o Subsequent increases in fair value are treated as unrealized gains and included in OCI.

Standard IFRS 9
Classification and measurement:

 All financial assets are measured at fair value when initially acquired.
 Debt securities are measured either at amortized cost or FVPL.
 HFT equity securities must be measured at FVPL. Other equity investments can be measured at
FVPL or FVOCI; however, the choice is irrevocable.

Reclassification:

 Reclassification of equity instruments is not permitted.


 Reclassification of debt instruments is only permitted if the objective for holding the assets has
changed in a way that significantly affects operations.
o There is no restatement of prior periods at the reclassification date.
o If the security is reclassified from amortized cost to FVPL, the asset is measured at fair value
with G/L recognized in P&L.
o If the financial asset is reclassified from FVPL to amortized cost, the fair value at the
reclassification date becomes the carrying amount.

II. Investments in Associates


Associates are corporate investments over which the investor exercises significant influence, but not
control (usually demonstrated by an ownership stake between 20% and 50%). Other indicators of
significant influence include:

 Representation on the board of directors


 Participation in the policy-making process
 Material transactions between the investor and the investee;
 Interchange of managerial personnel; or
 Technological dependency.
The equity method:

 The investment is initially recognized on the balance sheet at cost within a single line item under
noncurrent assets. The proportionate share of investee earnings increases the carrying amount,
while the proportionate share of losses and dividends decreases the carrying amount.
 The proportionate share of investee earnings is reported within a single line item on the income
statement. Dividend payments have no impact on the amount reported on the income
statement.
 If the value of the investment falls to zero, the equity method is discontinued. It may only be
resumed if the investor’s subsequent share of profit exceeds the losses not reported since
abandonment of the method.

Amortization of excess purchase price over book value:

 Excess purchase price is the difference between the purchase price and the proportionate share
in the book value of the investee’s net assets.
 Allocate the excess amount to its proportionate share in specific assets whose fair value exceeds
book value.
o Amounts allocated to inventory are expensed.
o Amounts allocated to depreciable or amortizable assets are capitalized and subsequently
expensed (depreciated or amortized).
o Amounts allocated to land and those that are not amortized continue to be reported at fair
value.
 Remaining excess is treated as goodwill, which is not amortized but reviewed periodically for
impairment. Goodwill continues to be recognized as part of the carrying amount.

Fair value option:

 The decision to apply the fair value method must be made at the time of initial recognition and is
irrevocable.
 The investment on the investor’s balance sheet is reported at fair value.
 Unrealized gains/losses arising from changes in FV as well as dividends and interest received are
included in the investor’s income.
 Under IFRS, fair value option is only available to venture capital companies, mutual funds, or
similar entities.

Impairment:

 Since goodwill is included in the carrying amount of the investment, it is not tested separately.
 Under IFRS, an impairment loss is recognized if there is evidence of a loss event and the
recoverable amount is less than the carrying amount.
o Recoverable amount is the higher of value in use and net selling price.
o Value in use is the discounted value of future cash flows expected from the asset.
o Net selling price is fair value less selling costs.
 Under U.S. GAAP, an impairment loss is recognized if the fair value is less than the carrying
amount and the decline is deemed to be permanent.
 Impairment results in a decrease in net income and reduces the carrying amount.
 Reversals of impairment losses are not allowed.

Transactions with associates:


 Profits must be deferred until they are confirmed through use or sale to a third party.
 Sales from the investee to the investor are called upstream sales, and sales from the investor to
the investee are called downstream sales.
 The investor must reduce its equity income and carrying value of the equity investment by the
amount of its proportionate share in unconfirmed profits.
 Proportionate share in unconfirmed profit = Profit × % Unconfirmed amount × % Ownership
interest.
 When unconfirmed sales are confirmed, profits that were not realized are realized and
contribute to equity income.

Joint ventures:

 A joint venture is a venture undertaken and controlled by two or more parties.


 Under both IFRS and U.S. GAAP, the equity method is used to account for joint ventures.
 Under rare circumstances, proportionate consolidation may be allowed. The proportionate
share of the joint venture’s assets, liabilities, income, and expenses are combined or shown on a
line-by-line basis with those of the investor.
 Net income and total net assets are the same under both methods. However, total assets,
liabilities, revenues, and expenses are different.

III. Investments in Business Combinations


A business combination is the combination of two or more entities into a larger economic entity.

 IFRS does not differentiate between business combinations based on the structure of the
surviving entity.
 U.S. GAAP categorizes business combinations based on the structure after the combination.
o Merger: Company A + Company B = Company A.
o Acquisition: Company A + Company B = (Company A + Company B).
o Consolidation: Company A + Company B = Company C.

The pooling-of-interests method (U.S. GAAP) or uniting-of-interests method (IFRS):

 The two companies are combined using their historical book values, and operating results are
restated as if they had always operated as a single entity.
 Ownership interests are continued and former accounting bases are maintained.
 Fair values are not used, and the actual acquisition price is not evident on the financial
statements.
 This method is now prohibited.

The purchase method:

 The combination is accounted for as a purchase of net assets, where net assets are recorded at
fair values.
 Compared to the pooling/uniting-of-interests method, the value of depreciable assets is higher
and the additional depreciation expense results in lower net income and lower total asset
turnover.
 This method has been replaced by the acquisition method.

The acquisition method:

 Consolidated financial statements:


o Excess purchase price is the difference between the purchase price and the book value of
the acquiree’s net assets.
o After the excess purchase price is allocated to all identifiable assets and liabilities to reflect
their fair values, the remainder is recognized as goodwill.
o Assets and liabilities are combined using book values of the acquirer’s assets and liabilities
and fair values of the acquiree’s assets and liabilities.
o All revenues and expenses of the acquiree are also combined with those of the parent.
o The acquirer’s equity accounts (after adjustments for newly issued stocks) are carried to the
combined entity. The acquiree’s equity accounts are ignored.
 Note:
o The acquirer must recognize assets and liabilities that the acquiree has not recognized on its
financial statements (e.g., brand names or patents developed internally).
o The acquirer must recognize any contingent liability assumed in the acquisition if it is a
present obligation that arises from past events and can be measured reliably. Costs expected
to be incurred are not recognized as liabilities but are expensed in the future as they are
incurred.
o The acquirer must recognize an indemnification asset if the acquiree contractually
indemnifies the acquirer for the outcome of a contingency, for an uncertainty related to a
specific asset or liability of the acquire, or against losses above a specified amount on a
liability arising from a particular contingency.
o If the purchase price is less than the fair value of the acquiree’s net assets, the acquisition is
referred to as a bargain acquisition. The difference is required to be recognized immediately
as a gain in P&L.
o Intercompany transactions are eliminated.

Business combinations with less than 100% acquisition:

 The parent and the subsidiary prepare their own financial statements, but the parent also
prepares consolidated financial statements for each reporting period.
 Non-controlling interests on the consolidated balance sheet (presented in the equity section)
reflects minority shareholders’ proportionate share in the net assets of the subsidiary.
 Non-controlling interests on the income statement (deducted from consolidated net income)
reflects minority shareholders’ proportionate share in the net income of the subsidiary.
 Intercompany transactions are eliminated.

Measuring goodwill and non-controlling (minority) interest:

 U.S. GAAP requires the use of the full goodwill method, while IFRS permits both the full goodwill
method and the partial goodwill method.
 The income statement is exactly the same under the full and partial goodwill methods.
 Full goodwill method:
o Goodwill = Fair value of subsidiary – Fair value of subsidiary’s identifiable net assets.
o Non-controlling interest = Proportionate share of subsidiary’s fair value = % Non-controlling
interest × Fair value of subsidiary.
 Partial goodwill method:
o Goodwill = Purchase price – Fair value of parent’s proportionate share of subsidiary’s
identifiable net assets.
o Non-controlling interest = Proportionate share of fair value of subsidiary’s identifiable net
assets = % Non-controlling interest × Fair value of subsidiary’s identifiable net assets.
 The full goodwill method results in higher assets and higher equity, which result in lower ROA
and ROE.
 Net income and retained earnings are the same under both methods. The non-controlling
interests share the burden of additional depreciation.

Impairment of goodwill:

 Goodwill must be tested at least annually or more frequently in certain events and
circumstances. Reversals of impairment losses are not allowed.
 Under IFRS:
o At the time of acquisition, goodwill is allocated to each of the acquirer’s cash-generating unit
that will benefit from the expected synergies from the business combination.
o Goodwill is impaired if the recoverable amount of the cash-generating unit is lower than its
carrying value (including goodwill).
o Impairment loss = Carrying value of unit - Recoverable amount of unit.
o The impairment loss is first absorbed by the goodwill allocated to the unit. The remaining
amount of the loss (if any) is allocated to all other assets in the unit on a pro rata basis.
 Under U.S. GAAP:
o At the time of acquisition, goodwill is allocated to each of the acquirer’s reporting unit.
o Goodwill is impaired If the fair value of the unit is lower than its carrying value.
o Impairment loss = Carrying value of goodwill - Implied goodwill.
o Implied goodwill = Fair value of unit – Fair value of unit’s net assets.
o The impairment loss is absorbed by the goodwill allocated to the unit. If implied goodwill is
negative, no adjustments are made to other assets or liabilities.

Impact of different methods on financial statements and ratios:

 Under the equity method, nonrecognition of the investee’s debt results in lower leverage ratios,
while nonrecognition of the investee’s revenues results in higher profit margins. Usually, the
equity method provides more favorable results than the acquisition method.
 The acquisition method results in higher assets, liabilities, revenues, and expenses than the
equity method. However, net income is the same under both methods.
o The full goodwill method results in higher total assets and equity compared to the partial
goodwill method. Therefore, ROA and ROE will be lower if the full goodwill method is used.
o Retained earnings and net income are the same under both methods, but shareholders’
equity is different (due to different noncontrolling interests).
Additional issues in business combinations:

 IFRS and U.S. GAAP differ on the treatment of contingent assets and liabilities.
o Under IFRS, contingent assets are not recognized, while contingent liabilities are recognized
(given that their fair values can be measured reliably) separately during the cost allocation
process.
o Under U.S. GAAP, contractual contingent assets and liabilities are recognized at their fair
values at the time of acquisition. Further, noncontractual contingent assets and liabilities
may also be recognized if it is “more likely than not” that they meet the definition of an
asset or liability at the acquisition date.
 A parent may agree to pay additional amounts to the subsidiary’s shareholders if the combined
entity achieves certain performance targets. This is referred to as contingent consideration.
o Under both IFRS and U.S. GAAP, contingent consideration should initially be measured at fair
value and be classified as a financial liability or equity.
o Subsequent changes in the fair value of these liabilities (and assets in case of U.S. GAAP) are
recognized in the consolidated income statement.
o Contingent consideration classified as equity is not remeasured under both IFRS and U.S.
GAAP. Any settlements are accounted for within equity.
 Under both IFRS and U.S. GAAP, in-process R&D acquired in a business combination is
recognized as a separate intangible asset at fair value. In subsequent periods, in-process R&D is
amortized.
 Under both IFRS and U.S. GAAP, restructuring costs associated with a business combination are
expensed in the period in which they are incurred (they are not included in the acquisition
price).

IV. Special Purpose Entity (IFRS) and Variable Interest Entities (U.S. GAAP)
SPEs are structured in a manner that allows the sponsoring company to retain financial control while
third parties hold the majority of the voting interests.

 In the past, sponsoring companies were allowed to avoid consolidation of SPEs on their financial
statements due to a lack of control of the SPEs. Consequently, they can report improved asset
turnover, higher profitability, and lower levels of operating and financial leverage.
 Sponsoring companies are now required to prepare consolidated financial statements that
account for arrangements where parties other than the holders of majority voting rights exercise
financial control over another entity.

Securitization of assets:

 SPEs are often set up to securitize receivables held by the sponsor. The SPE issues debt to
finance the purchase of these receivables from the sponsor, and interest and principal payments
to debt holders are made from the cash flow generated from the pool of receivables.
 An important aspect of the arrangement is whether the SPE’s debt holders have recourse to the
sponsor if sufficient cash is not generated from the pool of receivables. In this case, the
transaction is basically just like taking a loan and collateralizing it with the receivables. If the
receivables are not entirely realized, the loss is borne by the sponsor.
 If a sponsoring company were able to raise funds via an SPE and not be required to present
consolidated financial statements:
o Accounts receivable would decrease, and non-current liabilities would decrease compared
to a direct borrowing. The cash received would contribute to CFO.
o The sponsoring company would report a lower debt-to-equity ratio and a higher equity-to-
assets ratio compared to a direct borrowing.
 However, if accounting standards were to require consolidation of SPEs:
o Accounts receivable would remain the same, and non-current liabilities would remain the
same compared to a direct borrowing.
o The sponsoring company’s financial position would be the same regardless of whether it
raises the funds through an SPE or by borrowing directly.

Reading 18: Employee Compensation: Post-Employment and Share-


Based

I. Post-Employment Benefit Plans


Types of post-employment benefit plans:

 Defined-contribution plans:
o The company contributes a certain amount each period to the employee's retirement
account.
o The company makes no promise regarding the future value of the plan assets. Thus, the
employee assumes all of the investment risk.
o Pension expense is equal to the company's periodic contribution. Payments that are made
reduce CFO. If payments remain due as of the balance sheet date, these obligations are
classified as current liabilities.
 Defined-benefit plans (funded plans):
o The company 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.
o Since the employee's future benefit is defined, the employer assumes the investment risk.
o Accounting for the future obligations is complicated because many assumptions are involved
(employee turnover, average retirement age, life expectancy).
 Other post-employment benefits (unfunded plans):
o The employer promises to pay benefits to employees in the future but is not required to
make periodic contributions to, or hold assets in, a trust to fund associated obligations.
o Accounting for these post-employment benefits can be even more complex than accounting
for defined benefit pension plans as there is a need to estimate future increases in costs
(e.g., healthcare) over a relatively long time horizon.
Pension obligation and plans assets:

 Pension obligation:
o Pension obligation is referred to as the PV of the defined benefit obligation (PV of DBO)
under IFRS, and the projected benefit obligation (PBO) under U.S. GAAP.
o Calculating the pension obligation requires a company to make several actuarial
assumptions (e.g., discount rate, rate of future compensation increases, life expectancy of
employees).
o Pension obligation can be calculated using either the projected unit credit method (IFRS) or
Schweser’s method.
o Pension obligation changes as a result of current service costs, interest expense, past service
costs, changes in actuarial assumptions (i.e., actuarial gains and losses), and benefits paid to
employees.
 Plan assets:
o Defined-benefit plans are required to be funded. The employer must make periodic
contributions to the pension trust and is responsible for ensuring that plan assets are
sufficient to pay promised future benefits.
o The fair value of plan assets changes as a result of actual return on plan assets, contributions
made by the employer, and benefits paid to employees.
 The funded status of the plan:
o The net pension asset (liability) reported on the balance sheet equals the funded status of
the plan. Positive (negative) funded status is defined as a net pension asset (liability).
o Funded status = Fair value of plan assets – Pension obligation.
o If the fair value of plan assets is greater than the pension obligation, the plan is said to be
overfunded, and a net pension asset equal to the positive difference is recognized on the
balance sheet.
o If the fair value of plan assets is less than the pension obligation, the plan is said to be
underfunded, and a net pension liability equal to the negative difference is recognized on
the balance sheet.
o Refunds from the plans and reductions in future contributions reflect overfunding of the
plan. Therefore, the amount of net pension asset reported is subject to a ceiling equal to the
PV of these future economic benefits.

Periodic pension cost:

 Approach 1: Periodic pension cost = Employer contributions – ΔFunded status.


o Positive funded status is defined as a net pension asset.
o The periodic pension cost is either paid via contributions or deferred via a worsening of the
funded status.
o Periodic pension cost is not affected by employer contributions. If employer contributions
were higher, the ending funded status would automatically be higher.
 Approach 2: Periodic pension cost = Current service costs + Interest costs + Past service costs +
Actuarial losses – Actuarial gains – Actual return on plan assets.
o The periodic pension cost equals the increase in the pension obligation (excluding benefits
paid) minus actual return on plan assets.
o This approach is basically the same as the previous approach. The formula accounts for all
sources of change in the funded status except for employer contributions.

Periodic pension cost under IFRS:

 Periodic pension cost = Service costs + Net interest expense/income – Remeasurement.


 Service costs are recognized as an expense in P&L. They include both current and past service
costs.
 Net interest expense/income is recognized in P&L.
o Net interest expense/income = Net pension liability/asset × r = Pension obligation × r – Fair
value of plan assets × r.
o The discount rate r is the rate used to determine the pension obligation.
 Remeasurement amounts are recognized in OCI and are not subsequently amortized into P&L.
o Remeasurement include actuarial gains and losses and the difference between the actual
return on plan assets and the return on plan assets based on the discount rate r.
o Remeasurement = (Actuarial gains – Actuarial losses) + (Actual return on plan assets – Fair
value of plan assets × r).

Periodic pension cost under U.S. GAAP:

 Periodic pension cost = Service costs + Past service costs + Interest costs + Actuarial losses –
Actuarial gains – Expected return on plan assets.
 Service costs are recognized in P&L, but past service costs are recognized in OCI in the period
during which the change that gave rise to the costs occurred. In subsequent years, these past
service costs are amortized to P&L over the remaining service lives of the affected employees.
 Interest costs and expected return on plan assets are recognized in P&L.
o These two components are presented separately in P&L, not in a single net amount.
o The difference between the actual return and the expected return on plan assets is another
source of actuarial gains and losses. This additional source does not affect the funded status.
 Actuarial gains and losses can be recognized either in P&L or in OCI.
o Actuarial gains and losses include not only the impact of changes in actuarial assumptions
but also the difference between the actual and expected return on plan assets.
 If the actual return is greater than the expected return, an actuarial gain arises.
 If the actual return is less than the expected return, an actuarial loss arises.
o Under the corridor method:
 Typically, actuarial gains and losses are recognized in OCI.
 If the net cumulative amount of unrecognized actuarial gains and losses at the beginning
of the period exceeds the corridor, the excess is amortized into P&L as a component of
pension expense over the remaining service lives of the affected employees.
 The corridor is 10% of the greater of the pension obligation and the fair value of plan
assets.
Presentation of periodic pension cost:

 Certain pension costs may qualify for being capitalized and included as part of the cost of certain
assets (e.g., inventories). These capitalized pension costs are then included in P&L as part of
COGS when inventories are later sold.
 For pension costs that are not capitalized:
o IFRS only differentiate between components included in P&L and in OCI. It does not specify
where exactly the various components of pension cost must be presented. Components of
pension expense recognized in P&L may be presented separately.
o U.S. GAAP also differentiate between components included in P&L and in OCI. Further, they
require all components of pension expense recognized in P&L to be aggregated and
presented within one net line item on the income statement.
 Both IFRS and U.S. GAAP require total periodic pension cost to be disclosed in the notes to the
financial statements.
Effects of changes in key assumptions:

 An increase in the discount rate results reduces the opening pension obligation, typically reduces
the periodic pension cost (as interest costs and current service costs fall), and therefore reduces
the closing pension obligation.
 An increase in the compensation growth rate increases the total value of payments owed to
employees after retirement, therefore increases the pension obligation, service costs, interest
costs, and periodic pension cost.
 Under U.S. GAAP, an increase in the expected return on plan assets reduces pension expense.
However, it has no impact on periodic pension cost, since the decrease in pension expense is
offset by an increase in actuarial losses, which results from a lower difference between the
actual return and expected return from plan assets.
 An increase in the assumed life expectancy of affected employees increases the pension
obligations, service costs, interest costs, and periodic pension costs.

Adjustment for analytical purposes:

 Gross vs. net pension assets/liabilities: Netting pension assets and liabilities results in less total
assets and total liabilities than reporting the gross amounts. ROA would be lower and leverage
ratios would be higher with the gross amounts.
 Differences in assumptions used: Different assumptions result in different amounts of periodic
pension cost and pension expense. Accounting for other post-employment benefits also requires
companies to make several assumptions.
 Differences between IFRS and U.S. GAAP in recognizing components of periodic pension cost:
o Adjustments may be necessary to ensure uniform treatment of components. U.S. GAAP-
reported P&L can be adjusted to facilitate comparison with IFRS-reported P&L:
 Include past service costs on the P&L as pension expense.
 Exclude the effects of amortization of past service costs arising in previous periods.
 Exclude the effects of amortization of unrecognized actuarial gains and losses arising
in previous periods.
 Incorporate the effects of the expected return on plan assets based on the discount
rate (rather than the expected rate).
o Alternatively, comprehensive income (i.e., net income plus OCI) could be used as the metric
for comparison.
 Differences due to classifications in P&L:
o Under U.S. GAAP, pension expense is reported within a single line item as an operating
expense in P&L.
o Under IFRS, different components of pension expense may be reported within different line
items in P&L.
 Adjustments should be made to reflect a company’s operating performance more accurately:
o Add back pension expense to operating income.
o Subtract service costs before determining operating income.
o Add interest costs to interest (non-operating) expense.
o Add actual returns on plan assets to non-operating income.

Cash flow related information:

 For a funded plan, the impact of the plan on the sponsoring company’s cash flows is the amount
of contributions the company makes to fund the plan. For an unfunded plan, the impact of the
plan on the sponsoring company’s cash flows is the amount of benefits paid. In both cases, these
cash flows are usually classified as CFO.
 If a company’s contribution to the plan over the period is greater than the periodic pension cost,
the excess may be viewed as a reduction in the overall pension obligation. If a company’s
contribution to the plan over the period is lower than total pension cost for the period, the
shortfall results in an increase in the overall pension obligation.
 If the difference between contributions and periodic pension cost is material, analysts may
choose to reclassify the after-tax excess (shortfall) in contributions as a use (source) of cash from
financing activities rather than operating activities

II. Share-Based Compensation


Share-based compensation:
 Share-based compensation is a form of deferred compensation and includes items such as stock,
stock options, stock appreciation rights, and phantom shares.
 Advantages of share-based compensation:
o Share-based compensation aligns employees’ interests with those of shareholders.
o share-based compensation does not typically require a cash outlay.
 Disadvantages of share-based compensation:
o The employee may have limited influence on the company’s market value, so share-based
compensation may not necessarily provide the desired incentives.
o Increased ownership may make managers more risk-averse and conservative in their
strategies.
o The option-like (asymmetrical) payoff may encourage management to take excessive risk.
o Share-based compensation leads to dilution of existing shareholders’ ownership.
 Accounting for share-based compensation:
o Share-based compensation expense is based on the fair value of the compensation granted.
o Companies are required to disclose the nature and extent of share-based compensation for
the period, the basis for determining the fair value of share-based compensation over the
period, and the effects of share-based compensation on the company’s net income for the
period and its financial position.
 Different types of compensation can be categorized as equity-settled compensation and cash-
settled compensation.
o Equity-settled share-based compensation (e.g., stock grants and stock options) allow the
employee to obtain direct ownership in the company.
o Cash-settled share-based compensation (e.g., stock appreciation rights and phantom stock)
does not require the employee to hold shares in the company.

Stock grants:

 Stock grants include outright stock grants, restricted stock grants, and performance stock grants.
o Outright stock grants grant shares to the employee without any conditions.
o Restricted stock grants require the employee to return the shares to the company if certain
conditions are not met (e.g., if certain performance goals are not met).
o Performance shares are contingent on meeting performance goals, where performance is
usually measured by accounting earnings or return on assets. Performance shares may
provide incentives to management to manipulate reported earnings.
 Compensation expense for stock grants is based on the fair value of shares, which typically
equals their market value on the grant date. Compensation expense for stock grants is allocated
over the employee’s service period.

Stock options:

 Compensation expense related to stock options is based on fair value, where fair value must be
estimated using an appropriate valuation model.
 Assumptions of higher stock price volatility, longer estimated life, higher risk-free interest rate,
and a lower dividend yield increase the estimated fair value of employee stock options,
increasing compensation expense.
 Accounting for compensation expense:
o If stock options vest immediately, the entire cost (fair value) of options awarded is
recognized on the grant date (in the current period).
o If stock options vest after a specified service period, compensation expense is allocated over
the service period.
o If vesting of stock options is conditional (e.g., upon a target share price being reached),
compensation expense is recognized over the estimated service period.
 As option expense is recognized over the relevant period, expenses increase and net income
falls. Therefore, retained earnings also fall. The offsetting entry is an increase in paid-in-capital
so total shareholders’ equity remains unchanged.
 If the number of shares and option price are known, compensation expense is measured at the
grant date. If the fair value of options depends on events after the grant date, compensation
expense is measured at the exercise date.

Stock appreciation rights (SARs):

 SARs allow an employee’s compensation to be tied to increases in the company’s stock price, but
the employee does not own the company’s stock.
 Compensation expense for SARs is measured at fair value and allocated over the service life of
the employee.
 The potential for risk aversion is limited as SARs holders have limited downside risk and
unlimited upside potential. Also, ownership interests of existing shareholders are not diluted.
However, SARs require a current period cash outflow.

Phantom shares:

 Phantom shares allow employee compensation to be based on the performance of a


hypothetical stock rather than the company’s actual stock.
 Phantom share plans can be used by private companies, by business units within a company, and
by highly illiquid companies.

Reading 19: Multinational Operations

Currency terms:

 Presentation currency (PC) is the currency in which the parent company reports its financial
statements. It is typically the currency of the country where the parent is located.
 Functional currency (FC) is the currency of the primary business environment in which an entity
operates.
 Local currency (LC) is the currency of the country where the subsidiary operates.

I. Foreign Currency Transaction Exposure


A foreign currency is defined as any currency other than the entity’s FC. Foreign currency
transactions may involve an import purchase or export sale that is denominated in a foreign
currency, or borrowing or lending funds where the amount to be repaid or received is denominated
in a foreign currency.
 For an export sale, the exporter faces the risk that the value of the foreign currency will decrease
between the date of sale and the settlement date. Depreciation of the foreign currency would
mean that the exporter will receive a lower number of units of domestic currency upon
converting the foreign currency amount when it is received.
 For an import purchase, the importer faces the risk that the value of the foreign currency will
increase between the purchase date and the settlement date. Appreciation of the foreign
currency would mean that the importer will have to spend more units of domestic currency to
purchase the required amount of foreign currency to settle the obligation.
 Foreign currency transaction risk only arises when the transaction date and the settlement date
are different. Changes in the value of the foreign currency asset (in the case of an export sale) or
liability (in the case of an import purchase) from the settlement date to the payment date are
recognized as G/L on the income statement.
 If the balance sheet date occurs between the transaction date and the settlement date:
o Foreign exchange G/L are still recognized on the income statement (even though they have
not been realized) for the period in which the transaction occurred.
o Once the transaction is settled, additional G/L are recognized in the period during which
the transaction was settled.
o Aggregating the foreign exchange G/L over the two accounting periods results in an amount
that equals the actual realized G/L on the foreign exchange transaction.

Analytical issues and disclosures:

 Both IFRS and U.S. GAAP require foreign exchange transaction G/L to be recognized on the
income statement, regardless of whether or not they have been realized.
 Neither set of standards specifies where on the income statement these G/L must be presented
(either as a component of operating or non-operating income/expense). The placement of the
foreign currency transaction G/L affects operating profit margin, but has no impact on gross
profit and net profit margins.
 IFRS and U.S. GAAP require disclosure of the aggregate amount of G/L included in net income,
but do not require disclosure of whether they are classified as operating or non-operating
income/expense. Details regarding the exact line item in which they are included is also not
required.

II. Translation of Foreign Currency Financial Statements


There are 2 approaches to translating foreign currency financial statements:

 The current rate method is used to translate financial statements from FC to PC.
 The temporal method is used to translate financial statements from LC to FC.
Rules to determine the applicable translation method(s):

 If LC = FC ≠ PC, the current rate method is used to translate financial statements into to PC. Such
instances usually arise when the subsidiary is independent and its operating, investing, and
financing activities are decentralized from the parent.
 If LC ≠ FC = PC, the temporal method is used to translate financial statements into PC. Such
instances usually arise when the subsidiary and parent are well-integrated.
 If LC ≠ FC ≠ PC, the temporal method is used to translate financial statements from LC into FC,
and the current rate method is used to translate financial statements from FC into PC.

Exchange rate definitions:

 Current rate is the exchange rate that exists on the balance sheet date.
 Average rate is the average exchange rate over the reporting period.
 Historical rate is the actual exchange rate that existed on the original transaction date.

The current rate method:

 The income statement and the statement of retained earnings are translated first, and followed
by the balance sheet.
 All income statement accounts are translated at the average rate.
 All balance sheet accounts (except common equity) are translated at the current rate.
 Capital stock is translated at the historical rate that existed on the date of contribution.
 Dividends are translated at the rate that applied when they were declared.
 The cumulative translation adjustment (CTA) in the equity section is the plug figure that makes
the accounting equation balance.
 The translation G/L is the change in the cumulative translation adjustment over the year. An
increase a translation gain, while a decrease is a translation loss.

The temporal method:

 The balance sheet is translated first, followed by the income statement and the statement of
retained earnings.
 Balance sheet translation:
o Monetary assets (e.g., cash and receivables) and monetary liabilities (e.g., accounts payable,
accrued expenses, long-term debt, deferred taxes) are translated at the current rate.
o Nonmonetary assets and liabilities measured at historical cost (e.g., inventory measured at
cost under the lower of cost or market rule, PP&E, intangible assets, deferred revenue) are
translated at historical rates.
o Nonmonetary assets and liabilities measured at current value (e.g., marketable securities
and inventory measured at market under the lower of cost or market) are translated at the
rate that existed when current value was determined.
o Shareholders’ equity accounts (except retained earnings) are translated at historical rates.
o Ending retained earnings is the plug figure that makes the accounting equation balance.
 Income statement and statement of retained earnings translation:
o Revenues and expenses (other than expenses related to nonmonetary assets) are translated
at the average rate.
o Expenses related to nonmonetary assets (e.g., COGS, depreciation, amortization) are
translated at historical rates at the time of purchase of the related assets.
o Note that historical rates used to translate inventory and COGS will differ according to the
cost flow assumption used (FIFO, LIFO, AVCO).
o Dividends are translated at the rate that applied when they were declared.
o Net income equals the change in retained earnings over the year plus dividends declared.
 The translation G/L is reported on the income statement. It is the plug figure that equals the
difference between net income and income before translation G/L.

Balance sheet exposure under the two methods:

 Items translated at the current rate are revalued from one balance sheet date to the next and
exposed to translation adjustment.
o A foreign operation will have a net asset balance sheet exposure when the value of assets
translated at the current rate is greater than the value of liabilities translated at the current
rate.
o A foreign operation will have a net liability balance sheet exposure when the value of
liabilities translated at the current rate is greater than the value of assets translated at the
current rate.
 Whether the translation adjustment results in a gain or loss depends on the nature of the
balance sheet exposure (net asset vs. net liability) and the direction of change in the value of the
foreign currency (appreciating or depreciating).
 Under the current rate method:
o The parent’s foreign currency exposure equals the subsidiary’s net asset position.
o A company usually has a net asset exposure under the current rate method (unless the
entity has negative equity).
o Elimination of balance sheet exposure is rather difficult as it would require assets equal
liabilities.
 Under the temporal method:
o The parent’s exposure is limited to the subsidiary’s net monetary assets or liabilities.
o Most liabilities are monetary liabilities (translated at the current rate) while most assets are
nonmonetary assets (translated at historical rates). Therefore, a company usually has a net
monetary liability exposure under the temporal method.
o A company could eliminate its balance sheet exposure by reducing the net monetary liability
exposure to zero.

Translation analytical issues:

 Under the current rate method, pure balance sheet and income statement ratios are the same
after translation, while mixed ratios are different after translation.
 Under the temporal method, both pure and mixed ratios are distorted after translation.

III. Hyperinflationary Economies


Defining a high-inflation economy:

 U.S. GAAP defines a highly inflationary economy as one where the cumulative three-year
inflation rate exceeds 100%, which equates to an average of approximately 26% per year.
 IFRS provides no specific definition of high inflation, but does indicate that a cumulative three-
year inflation rate approaching or exceeding 100% indicates high inflation.

Adjusting financial statements for inflation:

 Under U.S. GAAP, the FC is assumed to be the parent’s PC and the temporal method is used. The
translation G/L is included in net income.
 Under IFRS, the subsidiary’s foreign currency accounts are restated for inflation and then
translated into the parent’s PC using the current rate.
o A company’s net monetary asset (liability) position is exposed to inflation risk as monetary
assets and liabilities are not restated for inflation.
 A company will recognize a purchasing power gain if it holds more monetary liabilities
than monetary assets.
 A company will recognize a purchasing power loss if it holds more monetary assets than
monetary liabilities.
o Purchasing power G/L from inflation are similar to translation G/L from depreciation of the
foreign currency when the temporal method is applied.
 A net monetary liability exposure combined with hyperinflation gives rise to purchasing
power gains.
 A net monetary liability exposure combined with foreign currency depreciation gives rise
to translation gains.
o There is no exposure to exchange rate risk because all foreign currency amounts are
translated at the current rate. No translation G/L is required.

Adjusting nonmonetary assets and liabilities for inflation under IFRS:

 Balance sheet adjustments:


o Nonmonetary assets and liabilities are restated for changes in the general purchasing
power of the local currency.
 Nonmonetary items carried at historical cost are restated for inflation by multiplying
their values by the change in the general price index from the date of acquisition to the
balance sheet date.
 Nonmonetary items carried at revalued amounts are restated for inflation by
multiplying their revised values by the change in the general price index from the date
of revaluation to the balance sheet date.
o Monetary assets and liabilities (e.g., cash, receivables, and payables) are not restated for
inflation.
o Shareholders’ equity accounts (except retained earnings) are restated for inflation by
multiplying their values by the change in the general price index from the beginning of the
period, or from the date of contribution (if later), till the balance sheet date.
o Ending retained earnings is the plug figure that makes the accounting equation balance.
 Income statement and statement of retained earnings adjustments:
o Income statement items and dividends are restated for inflation by multiplying their values
by the change in the general price index from the dates when the items were originally
recorded till the BS date.
o Net income equals the change in retained earnings over the year plus dividends declared.
 The G/L in purchasing power is the plug figure reported on the income statement.
 All items are then translated into the parent’s PC using the current rate.

Translation disclosures and analysis:

 Under both IFRS and U.S. GAAP:


o Companies are required to disclose the total amount of exchange differences (foreign
currency transaction G/L and translation G/L) recognized in net income. Companies are not
required to separate foreign currency transaction G/L from translation G/L (G/L arising from
applying the temporal method) on the income statement.
o Companies are required to disclose the total amount of the cumulative translation
adjustment classified as a separate component of shareholders’ equity, as well as a
reconciliation of the amount of the cumulative translation adjustment at the beginning and
end of the period.
 Disclosures relating to foreign currency translation are typically found in the MD&A section and
the notes to the financial statements in the annual report.
 Multinational companies typically have several subsidiaries in different regions so the translation
G/L on the income statement and the cumulative translation adjustment on the balance sheet
include the effects of translation of foreign currency accounts of all subsidiaries. Disclosures
relating to the parent’s exposures to individual currencies are limited.
 Two companies operating in the same industry may use different predominant translation
methods and net income reported by these companies would not be directly comparable. In
order to facilitate comparisons across companies, analysts may add the change in the cumulative
translation adjustment over the year to net income for the year.

II. Multinational Operations and the Effective Tax Rate of a Company


Multinational operations and the effective tax rate:

 Entities with operations in multiple countries with different tax rates have an incentive to set
transfer prices such that a higher portion of profits is allocated to lower tax rate jurisdictions.
This has prompted countries to establish various laws and practices to prevent aggressive
transfer pricing practices.
 The multinational owes the IRS taxes on the foreign income only to the extent that the U.S.
corporate tax rate exceeds the foreign rate of tax on that income. Further, much of the foreign
income earned by U.S. multinationals is not taxed until it is repatriated.
 Changes in the impact of foreign taxes on the parent’s effective tax rate can be caused by
changes in applicable tax rates and/or changes in the mix of profits earned in different countries
(with different tax rates).

Disclosures related to sales growth:

 For multinationals, sales growth can be attributed to changes in price, volumes, and/or exchange
rates.
 Analysts should consider organic sales growth because:
o Sales growth that comes from changes in price and volumes is arguably more sustainable
than growth from exchange rate movements.
o Management typically has greater control over sales growth from changes in volume or price
than from changes in exchange rates.
Reading 20: Evaluating Quality of Financial Reports

I. Quality of Financial Reports


Two interrelated attributes used for assessing the quality of a company’s financial statements are
financial reporting quality and earnings quality:

 Financial reporting quality refers to the usefulness of information contained in the financial
reports, including disclosures in the notes.
o High-quality reporting provides information that is useful in investment decision making in
that it is relevant and faithfully represents the company’s performance and position.
 Earnings quality (or results quality) pertains to the earnings and cash generated by the
company’s core economic activities and its resulting financial condition.
o High-quality earnings come from activities that the company will be able to sustain in the
future, and provide an adequate return on the company’s investment.
o The term earnings quality encompasses quality of earnings, cash flow, and balance sheet
items.

Quality spectrum of financial reports:

 Reporting is compliant with GAAP and decision useful; earnings are sustainable and adequate.
 Reporting is compliant with GAAP and decision useful; but earnings quality is low (not
sustainable or not adequate).
 Reporting is compliant with GAAP, but earnings quality is low and reporting choices and
estimates are biased.
 Reporting is compliant with GAAP, but the amount of earnings is actively managed to increase,
decrease, or smooth reported earnings.
 Reporting is not compliant with GAAP, although the numbers presented are based on the
company’s actual economic activities.
 Reporting is not compliant and includes numbers that are essentially fictitious or fraudulent.

Potential problems that affect the quality of financial reports:

 Reported amounts and timing of recognition:


o Aggressive, premature, and fictitious revenue recognition.
o Conservative revenue recognition.
o Omission and delayed recognition of expenses.
o Understatement of contingent liabilities.
o Overstatement of financial assets and understatement of financial liabilities.
o Increased CFO that result from deferring payments on payables, accelerating payments from
customers, deferring purchases of inventory, and deferring other expenditures.
 Classification:
o Accounts receivable can be reduced by selling them externally, transferring them to a
controlled entity, converting them to notes receivable, or reclassifying them as long-term
receivables. This results in a decrease in DSO and an increase in receivables turnover.
o Ending inventory can be reduced by reclassifying certain inventory costs as other assets. This
results in an increase in inventory turnover, a decrease in days of inventory on hand, and a
decrease in the current ratio.
o CFO can be inflated by classifying activities such as sales of long-term assets as operating
activities instead of investing activities, or capitalizing rather than expense operating
expenditures.
o Financial investments can be classified as AFS instead of HFT so that changes in their value
will flow through OCI rather than the income statement.
 Mergers and acquisitions:
o Companies that are finding it difficult to generate cash may acquire other companies to
increase CFO.
o A potential acquisition may create an incentive for management to use aggressive choices or
even misreport.
o Companies engaged in intentional misreporting are more likely than non-misreporting
companies to make an acquisition.
o Acquisitions also provide opportunities to make choices that affect the initial consolidated
balance sheet and consolidated income statements in the future.
 GAAP-compliant financial reporting that diverges from economic reality:
o Asset impairments and restructuring charges are recognized in a single period but they are
both likely the results of past activities over an extended period.
o Revisions to estimates, sudden increases in allowances and reserves, and large accruals for
losses may not reflect economic reality.
o Some economic assets and liabilities may not be reflected on the financial statements (e.g.,
operating leases, R&D expenses, sales order backlogs).
o Certain items presented in OCI may need to be included in net income for analytical
purposes. They include unrealized holding gains and losses of AFS securities and changes in
the revaluation surplus resulting from the revaluation model.

II. Evaluating the Quality of Financial Reports


Steps in evaluating the quality of financial reports:

 Understand the company, its industry, and the accounting principles it uses and why such
principles are appropriate.
 Understand management including the terms of their compensation. Also evaluate any insider
trades and related party transactions.
 Identify material areas of accounting that are vulnerable to subjectivity.
 Make cross-sectional and time series comparisons of financial statements and important ratios.
 Check for warning signs as discussed previously.
 For companies in multiple lines of business or for multinational companies, check for shifting of
profits or revenues to a specific part of the business that the company wants to highlight. This is
particularly a concern when a specific segment shows dramatic improvement while the
consolidated financials show negative or zero growth.
 Use quantitative tools to evaluate the likelihood of misreporting.

Quantitative models:

 The Beneish model:


o The Beneish is a probit regression model that estimates the probability of earnings
manipulation using eight dependent variables.

o The M-score determines the probability of earnings manipulation. Higher values indicate
higher probabilities.
o Generally speaking, a probability of earnings manipulation greater than 3.75%
(corresponding to an M-score greater than –1.78) is considered a higher-than-acceptable
probability of manipulation.
o As managers become aware of the use of such models, they are likely to game the model's
inputs. This concern is supported by an observed decline in the predictive power of the
model over time.
 The Altman model:
o The Altman model incorporates 5 financial ratios into a single model predict the probability
of bankruptcy.

o Each variable is positively related to the Z-score, and a higher Z-score is better as it means
less likelihood of bankruptcy.
o The model only uses one set of financial measures taken at a single point in time, and
reported values assume that the company is a going concern rather than one that may fail.
o Newer models have used both accounting-based and market-based data as predictive
variables.
 Limitations of quantitative models:
o Accounting is only a partial representation of economic reality. Underlying cause and effect
relationships can only be determined by a deeper analysis of actions.
o Managers have learned to test the detectability of earnings manipulation tactics by using
models to anticipate analysts’ perceptions. As a result, the predictive power of these models
has declined.

III. Earnings Quality


Indicator of earnings quality:

 Sustainable: High-quality earnings tend to persist in the future.


 Adequate: High-quality earnings cover the company’s cost of capital.

Sustainable earnings:

 Sustainable or persistent earnings are earnings that are expected to recur in the future. Earnings
comprised of a high proportion of non-recurring items are considered to be non-sustainable (and
hence low-quality).
 Classification of items as non-recurring is highly subjective and, hence, is open for gaming.
 Earnings persistence requires sustainability of earnings (excluding non-recurring items) and
persistence of growth in those earnings. Persistence can be measured by the coefficient β in the
following model:

 Earnings may be disaggregated into a cash component and an accruals component because
accrual accounting requires considerable subjectivity.

o The cash component of earnings is more persistent than the accruals component, so β1
tends to be greater than β2.
o The larger the accruals component of earnings, the lower the level of persistence and,
therefore, the lower the quality of earnings.
o Non-discretionary accruals arise from normal transactions, while discretionary accruals
arise from non-normal transactions or non-normal accounting choices, which are possibly
made with the intent to manage earnings.
o Abnormal discretionary accruals can be identified by modeling normal accruals and then
identifying outliers, or by comparing the magnitude of total accruals across companies.
 Other indicators of low-quality earnings:
o One metric used to identify potentially low-quality earnings is to look for those companies
that repeatedly meet or barely beat consensus estimates (benchmark).
o External indicators of low-quality earnings include enforcement actions by regulatory
authorities (e.g., SEC) and restatements of financial reports. They are not useful as they
cannot be used to forecast deficiencies before such deficiencies are publicly known.

Mean reversion in earnings:

 Mean reversion in earnings is tendency of earnings at extreme levels to revert back to normal
levels over time.
 Because of mean reversion, extreme earnings should not be expected to continue indefinitely.
Instead, analysts should focus on projecting normalized earnings over the relevant valuation
time frame.
 Mean reversion will occur faster for accruals-based earnings and even more so when such
accruals are discretionary.

Evaluate the earnings quality of a company:

 Revenue recognition issues:


o Revenue is the largest and most important element in the income statement, highly
vulnerable to manipulation. Analysts should concern with both quantity and quality of
revenue.
o Revenue generated via deliberate-channel stuffing or bill-and-hold arrangements should be
considered spurious and inferior.
o Genuine revenues secured via the use of heavy discounting practices still come at the
expense of deteriorating margins.
o A higher growth rate of receivables relative to that of revenue, as well as an increasing DSO
over time, is an indication of poor revenue quality.
 Steps in the analysis of revenue recognition practices:
o Understand revenue recognition practices including shipping terms, return policies, rebates,
and multiple deliverables.
o Compare receivable metrics with those from the past and with the industry median.
o Evaluate the proportion of earnings that are cash-based vs. accruals-based.
o Compare financials with physical data.
o Evaluate revenue trends by segments and compare with peers.
o Check for related party transactions.
 Expense capitalization:
o Understate an operating expense by capitalizing it boosts reported performance.
o Analysts should be wary of unsupported changes in major asset categories (e.g., an increase
in the proportion of PP&E over time).
 Steps in the analysis of expense recognition practices:
o Understand cost capitalization policies and depreciation policies.
o Perform trend and peer analysis regarding non-current assets, depreciation expense, and
capital expenditures.
o Check for related party transactions.

IV. Cash Flow Quality


Indicators of cash flow quality:

 Discussions of cash flow quality focus on CFO. For cash flows to be regarded as being of high
quality, there must be high results quality and high reporting quality.
 A cash flow statement should be evaluated in the context of the corporate life cycle as well as
industry norms.
o Early-stage startups have negative CFO and CFI and therefore financed by CFF.
o Mature companies have positive low-volatility CFO derived from sustainable sources
adequate to cover capital expenditures, dividends, and debt.
 Management can affect cash flows via strategic decisions:
o CFO can be boosted by selling receivables to a third party, which results in a decrease in
DSO.
o CFO can be boosted by delaying repayment of payables, which results in an increase in days
of payables.
o Cash flows can be misclassified (e.g., shifting inflows of cash from CFI or CFF to CFO).

Evaluating cash flow quality:

 Elements to check for in the statement of cash flows:


o Unusual items or items that have not shown up in prior years.
o Excessive outflows for receivables and inventory due to aggressive revenue recognition.
o Provisions for, and reversals of, restructuring charges.
 Management can shift cash flows from one classification to another since accounting standards
afford some flexibility (IFRS vs. U.S. GAAP). Such variation reduces comparability across
companies.

V. Balance Sheet Quality


Indicators of balance sheet quality:

 High financial results quality (a strong balance sheet) is indicated by an optimal amount of
leverage, adequate liquidity, and optimal asset allocation.
 High financial reporting quality is indicated by completeness, unbiased measurement, and clear
presentation.

Completeness:

 Off-balance-sheet obligations cause reported leverage to be understated. Analysts should


capitalize operating lease and purchase obligations by adding the PV of future lease or purchase
obligation payments to both assets and liabilities.
 For intercorporate investments, the equity method results in certain profitability ratio (e.g.,
profit margin and ROA) being higher than the acquisition method. Companies operating with
numerous unconsolidated subsidiaries for which ownership levels approach 50% may suggest
that the company is trying to avoid consolidating financial statements.

Unbiased measurement:

 The balance sheet should reflect subjectivity in the measurement of the values of pension
liabilities, investments that trade in non-active markets, goodwill, and impairment charges.
 Overstatement of asset values overstates profitability and equity.

Clear presentation:

 Companies have discretion in determining which items should be shown separately and which
ones should be grouped together.
 Clear presentation allows analysts to gather relevant information in the footnotes and make
comparisons across companies.

V. Source of Information about Risk


Sources of information about the risk of a business include financial statements, auditor's reports,
notes to financial statements, MD&A, and the financial press.

Reading 21: Integration of Financial Statement Analysis Techniques

I. The Basic Financial Analysis Framework


1. Define the purpose and context of the analysis.
2. Collect input data.
3. Process input data
4. Analyze/interpret the data.
5. Develop and communicate conclusions and recommendations.
6. Follow up.

II. Identify Financial Reporting Choices and Biases


Sources of earnings and ROE:

 ROE can be decomposed using the extended DuPont equation.

 The adverse impact on ROE of relatively weak areas of operations may be masked by other
stronger areas. For example, a company could offset a declining EBIT margin by increasing asset
turnover or increasing leverage.
 If equity income from associates is a significant source of earnings, analysts should remove the
equity income from earnings and the equity investment from total assets to eliminate any bias.

Asset base:

 Examine the composition of the balance sheet over time by presenting balance sheet items in a
common-size format.
 An increase in goodwill indicates that the company may have grown though acquisitions.

Capital structure:

 The capital structure must be able to support management's strategic objectives as well as to
allow the company to meet its future obligations.
 Liabilities such as employee benefit obligations, deferred taxes, and restructuring provisions may
or may not require a cash outflow in the future.
 If long-term liabilities are decreasing, there is a possibility of an offsetting change in working
capital, and working capital ratios should be analyzed.

Capital allocation and segment analysis:

 Analysis of geographical segments enables us to identify segments that are of greatest


importance to a company, and to understand any geopolitical investment risks faced by the
company.
 Segment disclosures are valuable in identifying the contribution of revenue and profit by each
segment, the relationship between capital expenditures and rates of return, and identifying
segments that should be de-emphasized or eliminated.

III. Adjustments for Differences in Accounting Standards, Methods, And


Assumptions
Operating leases should be brought onto the balance sheet and treated as finance leases.

 Increase assets and liabilities by the PV of the lease payments. This adjustment does not have
any impact on stockholders’ equity.
 Increase net income by the amount of rental expense.
 Decrease net income by the amount of interest and depreciation expense.
 Reclassify an amount equal to the reduction in lease liability each period as CFF instead of CFO.

Analysts should be aware of expected changes in accounting standards and should evaluate their
impact on a company’s reported financial performance and position.

IV. Balance Sheet Modifications, Earnings Normalization, And Cash Flow


Statement-Related Modifications
Accruals ratios:

 Earnings can be disaggregated into cash flow and accruals using either a balance sheet approach
or a cash flow statement approach.
 The lower the accruals ratio, the higher the earnings quality.

The balance sheet approach:

 Accruals are the change in net operating assets (NOA) over the period.

o NOA is the difference between operating assets and operating liabilities.


o Operating assets equals total assets minus cash, cash equivalents, and marketable securities.
o Operating liabilities equals total liabilities minus total debt (both short and long term).
 The accruals ratio is derived by dividing accruals by the average NOA for the period.

The cash flow statement approach:

 Accruals are derived by subtracting CFO and CFI from net income.

 The accruals ratio is derived by dividing accruals by the average NOA for the period.

Earnings and cash flow quality:

 Earnings are considered higher quality when confirmed by cash flows.


 Earnings are more easily manipulated than cash flows.
 Cash flows can be compared to operating income by adding back cash paid for interest and taxes
to CFO.
 Other cash flow ratios:
o Cash return on total assets = CFO / Average total assets.
o Cash flow to investment = CFO / Capital expenditures.
o Cash flow to total debt = CFO before interest and taxes / Total debt.
o Cash flow interest coverage = CFO before interest and taxes / Cash interest paid.

Market value decomposition:


 The standalone market value of a company can be computed by eliminating the pro-rata market
value of investment in associates.
 An implied P/E multiple can be computed by dividing the standalone market value by earnings
without regard to equity income from associates.

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