Financial reporting analysis CFA二级基础班

introducer：William

Financial reporting analysis

CFA二级基础班

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Ownership Influence Accountingtreatment

FinancialAssets <20% Nosignificantinfluence

FVPL:Tradingsecurities,DesignatedHTM:AmortizationcostAFS:FVOCI

Associates 20%-50% Significantinfluence

Equitymethod

Businesscombinations

>50% Control Acquisitionmethod

Jointventures Uncertain Controlissharedbytwoormoreentities

Equitymethod

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Reading13 Intercorporate Investments

Categories

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FinancialAssets

Ø Fair value through profit or lossü Trading assets(FVPL)ü Designated at fair value through profit or loss(FVPL)• Transaction costs are recognized in I/S, not included in initial fair value.

Ø Available-for-sale（FVOCI）Ø Amortised cost

ü Held-to-maturityü Loans and Receivables

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ØØüüüü

Trading assetsDesignated at fair value through profit or loss(FVPL)Financial asset with the intent to sell them in the near term.Recognition: fair value.Transaction costs are recognized in I/S, not included in initial fair value.Measurement: unrealized gains(loss) or realized gains(loss)recognizedin I/S.


Fair value through profit or loss

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Held-to-maturity

ü The investor has a positive intent and ability to hold the security tomaturity

ü transaction costs are included in initial costü Measurement: amortization costü changes in fair value are ignored.ü Sale: realized gains or losses recognized in I/S

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üüüüü

Øüü••ü•

Financial assets are not classified as HTM or FVPL.Recognition: fair valueTransaction costs are included in initial costMeasurement: fair valueUnrealized gain or losses is recognized in OCI.

Foreign exchange unrealized gains and lossesU.S.GAAP: all in OCI.IFRSEquity: OCI.Debt: 汇率变化引起的变动计入I/S; 其他变动计入OCI.SaleThe cumulative unrealized gain or losses recognized in OCI istransferred to I/S.


Available-for-sale

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Loans and ReceivablesØ IFRSü Amortized cost unless designated as either fair value through

profit or loss or available for sale.Ø US GAAPü Classified as held for trading, available-for-sale, or held-to-

maturity

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FVPL HTM AFS

Balancesheet FairvaluethroughPL

Amortizedcosttransactioncosts

Fairvaluetransactioncosts

Incomestatement

transactioncostsInterest,dividends,realized/unrealized/realizedG/L

InterestrealizedG/L Interest,

dividends,RealizedG/L

OCI N/A N/A UnrealizedG/L



Ø Ashort summary

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Reclassification

Ø IFRSü HTM can be reclassified asAFS, the difference between its

carrying amount and fair value is recognized in OCI.ü AFS can be reclassified as HTM, The fair value carrying amount

of the security at the time of reclassification becomes its new(amortized) ，any previous gain or loss that had been recognizedin OCI is amortized to I/S over the remaining life of the securityusing the effective interest method.

Ø U.S. GAAPü Reclassifications of securities between all categories are allowed.ü The treatment of unrealized gains and losses on the transfer date

depends on the initial classification of the security.

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ImpairmentsØ When the carrying amount is expected to permanently exceed its

recoverable amountü Fair value< carrying valueü The decline is determined to be permanent.Ø IFRSü Equity: reduced to the fair value, I/S.ü Prohibit the reversal of impairment losses through I/S, through

OCI.ü Debt: reduced to the present value of future cash flows, may not

be equal to the fair value, I/S.ü Only be reversed under the same conditions as impairments.Ø U.S. GAAPü Reduced to the fair value, I/S.ü Prohibit the reversal of impairment losses.

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Ø••üüüüüØ•••

Characteristic持股比例20%-50%持股比例少于20% but have significant influenceHave a seat in board of directors.Participate in policy making.Have material transactions with the company.Interchange of managerial personnel.Technology dependency.Equity method: one-line consolidationI/S: equity in income of the associateB/S: investment in associateRecognition: recorded on B/S at cost.


Associates

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AssociatesØ Measurement: recognize the investor's proportionate share of the investee's

earnings or losses.

Dividends received from the investee are treated as a return of capital an reducethe carrying amount the investment.

•

•

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Income Dividends

2010 200,000 50,000

2011 300,000 100,000

2012 400,000 200,000

Total 900,000 350,000



AssociatesExample: equity methodBranch purchases a 20% interest in Williams for 200,000 on 1 January 2010. Williamsreports income and dividends as follows:

Calculate the investment in Williams that appears on Branch’s balance sheet as of theend of 2012.

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AssociatesSolution:第一步：确认收益900000*20%=180,000，调整账面价值180,000第二步：确认股利，投资的回收350000*20%=70,000，调减账面价值70,000投资的账面价值=200,000+180,000-70,000=310,000

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Transactions with associatesØ Transactions with associatesü Upstream (associate to investor)ü Downstream (investor to associate)ü Equity inocme=(NI of associate- PL of internal transaction)*share

proportionØ Confirmed when it is transferred to third parties.

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Transactions with associates

Example: downstream saleIC owns 25% of TC, and applies the equity method of accounting. During 2011 IC sold96,000 of inventory to TC for 160,000. TC resold 120,000 of this inventory during 2011.The remainder was sold in 2012. TC reports income from its operations of 800,000 in 2011and 820,000 in 2012.1. Calculate the equity income to be reported as a line item on IC’s 2011 income statement.2. Calculate the equity income to be reported as a line item on IC’s 2012 income statement.

Solution to 1:In 2011 resold 120,000/160,000=75%，remainder 25%Downstream sale recognizes profit=160,000-96,000=64,000Equity income=(800,000-64,000*25%)*25%=196,000Solution to 2:Equity income=(820,000+64,000*25%)*25%=209,000

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Joint ventures

Ø Joint ventures• Ajoint venture is an entity in which control is shared by two or more

investors. Joint ventures are created in various legal and accountingfirms.

• Both U.S. GAAP and IFRS require the equity method of accountingfor joint ventures.

• proportionate consolidation is also allowed both in us.gaap and IFRSin some situations .

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Business CombinationsØ Business Combinations (controlling interest investments)• Merger吸收合并ü CompanyA+ Company B = CompanyA• Acquisition控股合并ü CompanyA+ Company B = (CompanyA+Company B）• Consolidation新设合并ü CompanyA+ Company B = Company CØ Acquisition method• All of the assets, liabilities, revenues, and expenses of the subsidiary are combined

with the parent. (equity×)• Parent's B/S “investment in subsidiaries” is eliminated.• Minority Interest is recognized in B/S and I/S (<100%Acquisition).• Transactions between the parent and subsidiary are eliminated.

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CompanyP CompanyT

Currentassets 40,000 16,000

Investmentinsubsidiary‐T 8,000 0

Otherassets 32,000 8,000

Total 80,000 24,000

Liabilities 40,000 14,000

Commonstock 28,000 6,000

Retainedearnings 12,000 4,000

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Business CombinationsØ Balance sheetExample:Suppose that on January 1, 2010, company P acquires 80% of the commonstock of company T by paying 8000 in cash to the shareholders of company T.The pre-acquisition balance sheets

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Acquisitionmethod Equitymethod

Currentassets 56,000 40,000

Investmentinsubsidiary‐T 8,000

Otherassets 40,000 32,000

Total 96,000 80,000

Liabilities 54,000 40,000

Commonstock 28,000 28,000

Retainedearnings 12,000 12,000

Minorityinterest 2,000 0

Total 96,000 80,000



Business CombinationsØ The post-acquisition balance sheets of company P

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Acquisitionmethod EquitymethodRevenue 80,000 60,000Expenses 56,000 40,000

EquityinincomeofT 3,200Minorityinterest 800Netincome 23,200 23,200

CompanyP CompanyTRevenue 60,000 20,000Expenses 40,000 16,000

Netincome 20,000 4,000Dividendpaid 1,000



Business CombinationsØ Income statement

The pre-acquisition Income statement

The post-acquisition Income statement of company P

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GoodwillØ Investment costs> the fair value of the identifiable net assetsthe difference is goodwill.

Example: goodwillAssume that Blake Co.Acquires 30% of the outstanding shares ofBrown Co.At the acquisition date, book values and fair values ofBrown’s recorded assets are 320,000, 370,000 respectively, the bookvalue and fair value of liabilities is 100,000. Blake Co. Believes thevalue of Brown is higher than the fair value of its identifiable net assets.They offer 100,000 for a 30% interest in Brown, Calculate goodwill.

Solution:Goodwill=purchase-fair value of net assets=100,000-(370,000-100,000)*30%=19,000.

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fair value&book value

Ø The fair value of the identifiable net assets>the book value of the investee• Amortization of Excess Purchase Price is these differences are amortized to

the investor's proportionate share of the investee's profit or loss over theeconomic lives of the assets.

Example:On 1 January 2011, Parker Company offered 500,000 for a 30% interest in PrinceInc. The book values and fair values of Prince Inc’s net assets is 1200,000,1,500,000 respectively, the difference is from an equipment which has 10 years ofremaining life. Prince reports net income for 2011of 100,000 and pays dividends of 50,000 . Calculate the following:• Goodwill included in the purchase price.Investment in associate at the end of 2011.

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fair value&book value

Solution to 1:Goodwill=500,000-30%*150,000=50,000.

Solution to 2:500,000+30%*[100,000-(1,500,000-1,200,000)/10-50000]=506000

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GoodwillØ Goodwill• Positive goodwillü Full goodwill (U.S.GAAP and IFRS)

u

u Higher assets, higher equity, overestimate goodwill compared with partial goodwill.ü Partial goodwill (only IFRS)

u

ü It is not amortized. Instead, it is tested for impairment annually or more frequently if events orcircumstances indicate that goodwill might be impaired.

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ØØüüü

Øüüüü

ImpairmentIFRSone-step approachCash generating unit(represents the lowest level within the combined entity)Carrying value of cash generating unit > recoverable amount (清算价值和going concern取较大值)U.S. GAAPtwo-step approachreporting unitStep1, carrying value of reporting unit.>fair valueStep2, carrying value of goodwill-implied goodwill(fair value of net asset-fair value ofidentifiable net asset)


Goodwill

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Goodwill

Example:Acquirer contributes $800,000 for an 80% interest inAcquiree. Theidentifiable net assets have a fair value of 900,000. the fair value of the entireentity is determined to be 1,000,000. Calculate the full goodwill and partialgoodwill.

Solution:Full goodwill: fair value of entity-fair value of identifiable=1,000,000-900,000=100,000.

Partial goodwill: purchase price – fair value of identifiable *%=800,000-900,000*80%=80,000.Sources from curriculum P68.

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GoodwillExample: IFRS ImpairmentThe cash-generating unit of a French company has a carrying value of1,400,000, which includes 300,000 of allocated goodwill. The recoverableamount of the cash-generating unit is determined to be1,300,000, and the estimated fair value of its identifiable net assets is1,200,000. Calculate the impairment loss.

Solution:Impairment loss =carrying value1,400,000-recoverable amount1,300,000=100,000.

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GoodwillExample: U.S. GAAP ImpairmentAUS firm has a fair value of 1,300,000 and a carrying value of 1,400,000that includes recorded goodwill of 300,000. The estimated fair value of theidentifiable net assets of the company at the impairment testdate is 1,200,000. Calculate the impairment loss.

Solution:Step1, FV 1,300,000 < carrying value of 1,400,000.Step2, Implied Goodwill=1,300,000-1,200,000=100,000.Impairment loss=300,000-100,000=200,000.

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Pooling of Interests and Purchase Methods

Ø Pooling of Interestsü Assets and liabilities were recorded at book valuesü the combined companies were portrayed as if they had always

operated as a single economic entity.ü pre-combination retained earnings were included in the balance

sheet of the combined entityü neither IFRS nor US GAAP allows use of the pooling/uniting of

interests method.Ø Purchase Methodsü Replaced by acquisition method

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SPE&VIE

Ø SPEü Special purpose entities (SPEs) are enterprises that are created to accommodate specific needs

of the sponsoring entity.ü SPEs can be a legitimate financing mechanism for a company to segregate certain activities

and thereby reduce risk.Ø variable interest entity (VIE)ü Absorb the majority of the VIE’s expected losses,ü Receive the majority of the VIE’s residual returns,ü both of the above two situation.

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Cash 30M Debt 0Accountreceivable

60M Equity 90M

Totalasset 90M TotalD&E 90M



SPE&VIE

Example:CompanyA: Balance Sheet

目的：剥离资产并融资公司A打算以应收账款作为抵押贷款55M，目前有两个方案可供选择：方案1：A公司直接以应收账款最为抵押借款55M；方案2：A公司投资5M成立SPE,并将应收账款60M转到SPE，以SPE的名义借款55M，SPE支付A公司60M现金；(A控股B，B控股SPE。其中，A公司拥有B 公司70%股权，B公司拥有SPE 60%股权。表面上，A公司只持有SPE公司70%*60%=42%股权，未达到50%以上控股权。但是，实际上A公司是间接控制SPE。)

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Cash 85M Debt 55MAccountreceivable 60M Equity 90MTotalasset 145M TotalD&E 145M

http://www.rycfa.com/


SPE&VIE

借款后的财务报表方案1：

方案2：CompanyA: Balance Sheet（合并前）


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Cash 85M Debt 55MAccountreceivable 60M Equity 90MTotalAsset 145M TotalD&E 145M



SPE&VIE

合并SPECompanyA: Balance Sheet（合并后）

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融通智慧

summary

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CFA Level 2长线班视频课程

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Reading 14 Employee Compensation

Types of post-employment benefit plans

Ø DC Plan (a defined contribution pension plan) is a retirement plan whereby the firm contributes a certain sum each period to the employee's retirement account.

ü Contribution: employer and employeeü Risk: taken by employeeü B/S: not recognized on employer's B/S.Ø DB Plan (a defined benefit pension plan) : the firm promises to make periodic

payments to the employee after retirement.ü Contribution: employerü Risk: taken by employerü B/S: recognized on employer's B/S.Ø Other post-retirement benefits (OPB)ü Including life insurance premiums, health insurance......ü Complexity in reporting for OPB may be even greater than for DB pension

plans because of the need to estimate future increases in costs

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Measuring DB plan

Ø Measuring PBO (projected benefit obligation)or PVDBO• Conceptsü The actuarial present value of future pension or present value of defined

benefit obligation in IFRS.Ø ABOü accumulated benefit obligationü includes no assumption about future compensation levelsØ Calculationü An estimate of future compensationü Going concern assumption• The firm will is a going concern.• The employee will continue to work for the firm till retirement.ü Assume expected future salary increases.ü Discount rate• high-quality corporate bonds


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Measuring DB plan

Example:2016.1.1, Under DB plan, A is promised an annual payment of 2% of his final annual salaryfor each year of service. The pension benefit will be paid at the end of each year, beginning one year after retirement. A’s starting annual salary is $50,000.In order to calculate the PBO at the end of the first year, we will assume•The discount rate is 8%•A’s salary will increase by 4% per year (the rate of compensation growth)•A will work for 25 years.•A will live for 15 years after retirement and receive 15 annual pension benefit payments.


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Measuring DB plan

Solution:At the end of first year:•FV25=50,000*(1+4%)24=128,165.21 (2040). Retirement received=128,165.21*2%*1=2563.3 per year.•The present value of pension payment at 2040: PMT=2563.3, N=15, I/Y=8, FV=0, CPT,PV=21940.55The present value of pension payment at the end of 2016=21940.55/1.0824=3460=PBO.


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Measuring DB plan

Ø Components• Current service costsü Employees earned the benefit after retirement during the current period.• Interest costü Interest cost=PBOB* r• Past service costü The retroactive benefit belongs to employees when a plan is initiated or

amended.• Actuarial losses/gainsü Changes in assumptions (retirement age, mortality) result in gains or losses in

PBO.• Benefit paid to employee


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Measuring DB plan

At the end of second year:•Retirement received=128,165.21*2%*2=5126.61per year.•The present value of pension payment at 2040: PMT=5126.62, N=15, I/Y=8, FV=0, CPT,PV=43881.11•The present value of pension payment at the end of 2017=43881/1.0823=7473.62=PBO.Current service cost:•128,165.21*2%*1=2563.3 per year.•PMT=2563.3, N=15, I/Y=8, FV=0, CPT,PV=21940.55•PV23=21940.55/(1.08)23=3736.81Interest cost:•3460.01*8%=276.8Ending PBO:PBOB3461.01+current service cost 3736.81+Interest cost 276.8=7473.62.


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Measuring DB plan


Ø Pension assetü employer contributionü actual returnü benefit paid to employee(pension asset and PBO)Ø Funded statues=ü pension asset-pension liabilityü Funded statues>0, overfunded, a net pension assetü Funded statues<0, underfunded, a net pension liability.Ø Asset Ceiling ü Present value of future economic benefitsü refunds or reductions of future contributions

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Financial statement reporting

ü The asset ceiling the present value of future economic benefits, such as available future refunds and reductions in future contributions

Example:Company A, the present value of the company’s defined benefit obligation is 6000 and the fair value of the pension plan’s assets is 4000. Company B, PVDBO is 5500 and the fair value of the pension plan’s assets Is 6000. In addition, the present value of available future refunds and reductions in future contributions is 300. Calculate the amount each company would report as a pension asset or liability on its

Solution to 1:Report a pension liability=6,000-4,000=2,000.Solution to 2:6000-5500=500> the asset ceiling 300, report a net pension asset 300.


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DB plan in IFRS


Ø I/S item• Service costs ü Current service cost员工多工作一年,养老金增加额的现值ü Past service cost养老金计划改变且追溯调整时产生PSC.• Net interest expense/income is recognized in I/S.ü Interest expense: PBO0*rü Interest income: pension asset0*rØ OCI• Remeasurement ü Actuarial gains and lossesü Differences between the actual return on plan assets and

expected return （Interest income: FV0*r）r(discount rate).

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DB plan in IFRS

I/S:Current service costPast service cost Int exp discount rate(r) Int Income(exp return) B/SPension Asset① Employer contribution② Actual return--Equity--benefit paid to employet

PBO① Current service ext② P S C③ Int exp +acturial loss-acturial gain-benefit paid to employeEquity difference between/actual return/expect return-OCI acturial gain or loss


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DB plan in US.GAAP


Ø I/S• Current service costü Recognized in I/S. 员工多工作一年,养老金现值增加额• Interest expenseü PBO0*r is recognized in I/S.• Expected returnü Pension asset*E(R) is recognized in I/S.• Amortizationü Amortization of past service cost养老金计划改变且追溯调整时产生

PSC.(PSC直接在OCI中确认，然后按员工后续工作年限摊销)ü Amortization of actuarial gains and lossesu Differences between the actual return on plan assets and expected return

资产实际收益和预期收益之差u Changes in PBO arising from changes in actuarial assumptions.精算假设

改变导致PBO的变化值。u 摊销部分入I/S,未摊销部分计入OCI。

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DB plan in US.GAAP

I/S:① Current service cost② Int exp③ expected return(Int income) r(expected return) past service lost④ Amotisization 广义Acuturial gain Pensionaset① Employer contribution② Actual return--benefit paid to employet

PBO① Current service cost② Int exp③ +acturial loss/-acturial gain-benefit paid to employetequity PSC unamortised part 狭义Acturial G/L OCI 广义Acturial g/L

狭义Acturial G/L Difference

Difference


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Total Periodic pension cost

Ø Total periodic pension cost (TPPC)• The change in net pension liability or asset-excluding the effect of the employer’s

periodic contribution into the plan.

•

•

• The retirement payment to the employees does not influence the net pension liability or asset, because the payment reduces plan assets and plan obligations in the same amount.


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Total Periodic pension cost


Ø The periodic pension cost is recognised in profit or loss (P&L) and/or in other comprehensive income (OCI).

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Corridor approach to amortization

Ø Corridor approach (US only)

• • 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.ü The amortization of an actuarial loss increases periodic pension cost in P&L.ü The amortization of an actuarial gain decreases periodic pension cost in P&L.• The application of corridor has to be consistent over time.


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Corridor approach to amortization

Assume that the beginning balance of the defined benefit obligation is 5,000,000, the beginning balance of fair value of plan assets is 4,800,000, and the beginning balance of unrecognised actuarial losses is 600,000. The expected average remaining working lives of the plan employees is 10 years. which is the amount of amortization in US.GAAP. the corridor is 500,000, which is 10 percent of the defined benefit obligation (selected as the greater of the defined benefit obligation or the fair value of plan assets). Because the balance of unrecognised actuarial losses exceeds the 500,000 corridor, amortisation is required. The amount of the amortisation is10,000, which is the excess of the unrecognised actuarial loss over the corridor divided by the expected average remaining working lives of the plan employees (600,000 – 500,000) ÷ 10 =10000


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Comparison

Component IFRS U.S. GAAP

Current service cost I/S I/S

Past service cost I/S Amortized in I/S; Unamortized in OCI

Interest cost I/S: PBO0*r I/S: PBO0*rExpected return I/S: FV0*r(interest income) I/S: FV0*E(R)

Actuarial gains/losses All in OCI, not amortized Amortized in I/S; Unamortized in OCI(corridor approach)

Remeasurements:Actuarial gain/losses

Dif(actual return-expected return)

Actuarial gain/lossesDIF(actual return-E(R))

(corridor approach)


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Example

DB plan for the fiscal year ending 20*5:

Unamortized actuarial losses(U.S. GAAP only) 3150•Expected rate of return on plan assets 6%•Discount rate used in estimating benefit obligation 7.5%

Beginning of year plan assets 28322 Beginning of year benefit obligation 38750

End of year plan assets 30682 End of year benefit obligation 43619

Actual return on plan assets 1795 Current service cost 1850

Employer contributions 1200 Past service costs 120

Benefits paid 635 changes in actuarial loss 628


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Example

Calculate:1. Beginning and ending funded status2. Total periodic pension cost3. Periodic pension cost reported in P&L underU.S. GAAP(ignore amortization of past service cost)4. Periodic pension cost in reported in P&L under IFRS5. Periodic pension cost reported in OCI under U.S. GAAP6. Periodic pension cost reported in OCI under IFRS


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Example

Solution:1. Beginning funded status=28322-38750= -10428. Ending funded status=30682-43619= -12937.

2.Total periodic pension cost=Employer contribution-Change in funded status=1,200-[-12,937-(-10,428)]=3,709.TPPC=Current service cost+ interest cost + Past service cost+ Actuarial losses-actual return=1850+2906+120+628-1795=3709.

3.Periodic pension cost in P&L (U.S. GAAP)•Corridor approachBeginning PBO>Beginning plan assets, we take 10% of beginning PBO:3875.Since unamortized actuarial losses do not exceed 10% of beginning PBO, no amortization is necessary.


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Periodic pension cost

•Periodic pension cost in P&L:current service cost 1850+interest cost 2906-expected return1699(6%*28,322)=3057.

4.Periodic pension cost in P&L (IFRS)Current service cost 1850+past service cost 120+Net interest cost 782(10428*7.5%)=2752

5.Periodic pension cost in OCI=total periodic pension cost-periodic pension cost in P&L Periodic pension cost in OCI(U.S.GAAP)=3709-3057=652.

6.Periodic pension cost in OCI(IFRS)=3709-2752=957.

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Reading14 Employee Compensation

Assumptions changes

Ø Discount rate• We use the required return of high-quality corporate bond as the

discount rate.• The discount rate increasesü PBO↓, improve the funded status of the plan.ü Current service cost ↓, total periodic pension cost ↓.ü Interest cost=PBO*ru Usually decreases.u If the plan is near mature, interest cost increases.Ø Rate of compensation growth• The compensation growth rate increasesü PBO ↑, deteriorate the funded status of the plan.ü Current service cost ↑, total periodic pension cost ↑.ü Interest cost ↑ =PBO ↑ *r

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Assumptions changes

Ø Expected return on plan assets (U.S. GAAP) increase• Periodic pension cost reported in P&L decreases.• Have no effect on total periodic pension cost, PBO or the funded

status of the plan.Ø A short summary

Effect on Discount rate↑ Compensation growth rate ↑

Expected rate of return ↑

Balance sheet liability ↓ ↑ No effect

Total periodic pension cost ↓(not for mature plan) ↑ No effect

Periodic pension cost in P&L ↓(not for mature plan) ↑ ↓(U.S. GAAP only)

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Assumptions changes

Ø Ultimate healthcare trend rateü The ultimate healthcare trend rate will be constant, but the near term healthcare

inflation rate will fluctuate in the near term.ü In the near term , if healthcare inflation rate increases• PBO ↑, periodic expense ↑Ø Analystü Compare the assumptions across similar firms over timeü Check whether the assumptions are internally consistent.ü Check whether the assumptions are consistent with economic enviroment


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Analyst’s adjustment


Ø Classification of Periodic Pension Costs Recognised in P&L

ü Components of this expense could be classified as operating and/or non-operating expenses. only the current service cost component is an operating expense

• adding back the full amount of pensions costs reported in the P& L (pension expense) and then subtracting only thecurrent service costs

ü Interest expense of that borrowing can be considered a financing cost

• The interest expense component would be added to the company’s interest expense

ü The return on pension plan assets is conceptually similar to returns on any of the company’s other financial assets

• Actual return on plan assets would be treated as non-operating income.

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Example:Reclassify the components of periodic pension cost between operating and non-operating items for analysis purpose:Partial income statementOperating profit 145,000Interest expense (12,000)Other income 2,000 Income before tax 135,000Other data Current service cost 7,000

Interest cost 5,000

Expected return on assets 8,000

Actual return on assets 9,500


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Solution:Periodic pension cost=current service cost 7,000+interest cost 5,000-expected return on assets 8000=4,000 is added back to operating profit.Service cost 7000 is subtracted from operating profit.Interest cost 5000 is added to interest expense.actual return 9500 is assed to other incomePartial income statementOperating profit 145,000+4,000-7,000=142,000Interest expense (12,000)-5000=(17,000)Other income 2,000+9,500=11,500 Income before taxIncome before tax 136,500


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Example: Income statement

Revenue 18,020

Net operating expenses (15,401)

Operating profit 2,619

Interest payable and similar charges (879)

Interest receivable and similar income 316

Other information

Share of post-tax results of associates 873

Profit before taxation 2,929

pension OPB TotalCurrent service

cost (8) (3) (11)

Interest costs (29) (10) (39)Expected return

on assets 14 14

Total (23) (13) (36)Actual return on

assets 47

1. Adjust pre-tax income for the actual rather than expected return on plan assets.Adjust the individual line items on the company’s income statement to reclassify the components of the pension and other post-retirement benefits expense as operating expense, interest expense, or interest income.


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Solution:1.Expense is 23, the actual return on plan assets of 47, the total P&L=8+29-47=-102.Use actual return rather than expected return, higher by 47-14=33 and will total 2962.

Reported Adjustments AdjustedRevenue 18,020 18,020

Net operating expenses -15,401 -15,401

Operating profit 2,619 +36-11 2644

Interest expense -879 -39 -918Interest and investment income 316 +47 363

Share of post-tax results of associates 873 873Profit before taxation 2,929 33 2,962


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Ø Cash flow statement ü U.S GAAP,• Contribution by employer, CFO.ü IFRS• contribution by employer.CFO or CFF


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Ø Cash flow information adjustment ☀• Overcontribution: Firm’s contribution>TPPC, repayment.ü

• Undercontribution: Firm’s contribution<TPPC, source of borrowing.ü

CFO CFF Total cash flowOvercontribution:

repayment Increase Decrease Remain constant

Undercontribution: borrowing Decrease Increase Remain constant


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Example:DB plan, the company made a 340 million contribution to the plan during the year.•Funded status at the beginning of the year 2530•Funded status at the end of the year 2180•Net income during the year is 812 million. CFO is 948 million and CFF is 112 million.•Tax rate=40%.1.Calculate the total periodic pension cost during the year.2.Calculate CFO and CFF after making appropriate adjustments.

Solution:1. TPPC=340-(2180-2530)=690.2. Adjusted CFO: 948-350*(1-40%)=738.Adjusted CFF: 112+350*(1-40%)=322.


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Share-based compensation

Ø Equity settled share-based compensationü Stock options• grant date.：the date that the compensation approved• Service period: the period between grant date and vesting date.• Vesting date: the date that employees can first exercise the stock option.• Exercise date: employees receive the stocks.• Recognised based on fair value of the stock option on the grant date.• Net income decreases• Retained earning decreases and additional paid-in-capital increases at the same amount ,no

change in equity.ü Stock grants• Based on market value of the stock on the grant date.u Net income decreasesu Retained earning decreases and additional paid-in-capital increases at the same amount ,no

change in equity.• Strengthsü Align employees’ interests(managers) with shareholders.


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Share-based compensation

Ø Weakness• The receivers have limited influence over the company’s market value(market

declines).• Lead managers to be risk averse or excess risk seeking.Ø Cash settled share-based compensation• Stock appreciation rightsü Employees have the right to receive the profit of price increase at a predetermined

quantity.• Phantom stockü Based on the performance of hypothetical stock.ü Suitable for illiquid stock or privately held firm.• Strengthsü Employees have limited downside risk and unlimited upside potential.ü No shares are issued, no dilution to existing shareholders.• Weaknessü Require cash outlay right now.


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Summary


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THANKS!

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financial reporting analysis LEVEL 2

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Reading15 Multinational Operations

Foreign Currency Transactions

Ø Foreign Currency Transactions• Conceptsü Makes an import purchase or export sale.ü Borrows or lends funds where the amount to be repaid or received is dominated

in a foreign currency.• Settlement before balance sheet date• Settlement intervening balance sheet date• Transaction gain or loss →I/S→RE

Transaction Exposure Foreign Currency Strengthens Weakens

Export sale Asset(AR) Gain Loss

Import purchase Liability(AP) Loss Gain

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Example: before B/S dateFinnCo purchases goods from its Mexican supplier on 1 November 2011, the purchase price is 100,000 Mexican pesos.Credit terms allow payment in 45 days, and FinnCo makes payment of100,000 pesos on 15 , December 2011. FinnCo’s functional and presentation currency is the euro.Spot exchange rates:1 November 2011 MXN1=EUR0.068415 December 2011 MXN1=EUR0.0703FinnCo’s fiscal year end is 31 December. How will FinnCo account for this foreign currency transaction ,and what effect will it have on the 2011 financial statement?

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Solution:11.1 Purchase借：Inventory EUR6840贷：Accounts payable EUR684012.15 Settlement借：Accounts payable EUR6840Foreign exchange loss EUR190→I/S→RE贷：Cash EUR7030

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Example: intervening B/S dateFinnCo sells goods to a customer in the United Kingdom for £10,000 on 15 November 2011, with payment to be received in British pounds on 15 January 2012. FinnCo’s functional and presentation currency is the euro. Spot exchange rates:15 November 2011 £1=€1.460; 31 December 2011 £1=€1.480; 15 January 2012 £1=€1.475 FinnCo’s fiscal year end is 31 December. How will FinnCo account for this foreign currency transaction , and what effect will it have on the 2011 and 2012 financial statement?

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Solution:•Sold 11.15Account receivable €14,600•Balance sheet date 12.31借：Account receivable €200 (调增200至14,800)贷：Foreign exchange gain €200→I/S→RE•Payment 1.15借：Cash €14,750Foreign exchange loss EUR50→I/S→RE贷：Account receivable €14,800

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Ø Analytical Issues• Foreign exchange gains and losses are treated asü A component of other operating income/expenseü A component of non-operating income/expense• Two companies in the same industry could choose different alternatives, which

would distort the comparison of operating profit and operating profit margins between those companies.

Ø Disclosures• Both IFRS and US GAAP do not require disclosure of the line item in which

these gains and losses are located.• IFRSü amount of exchange rate differences recognized in profit or loss.• U.S.GAAPü the aggregate transaction gain or loss included in determining net income for the

period.”

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Foreign Currency Financial Statements Translation

Ø Currency• The presentation currency ( or reporting currency)is the currency in which

financial statement amounts are presented.• The functional currency is the currency of the primary economic environment

in which an entity operates.• The local currency is the currency where the company operates.

Ø Method• When PC=FC≠LC, the temporal method;• When PC≠FC=LC, the current rate method;• When PC≠FC≠LC, first the temporal method and then the current rate method.

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Translation Methods

Ø Current rate methodü I/S• All items are translated at the average exchange rate.ü B/S• All assets and liabilities are translated at the current exchange rate (the

spot exchange rate on the B/S date).• Capital is translated at the historical exchange rate.• retained earning is balance item.• the difference recored as CTA(Cumulative translation adjustment)ü Dividendü dividend are translated at the historical exchange rate at declare date

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Translation Methods

Ø Temporal rate methodü B/S• Monetary assets and liabilities are translated at the current

exchange rate;• Non-monetary assets and liabilities are translated at the historical

exchange rate.• Capital is translated at the historical exchange rateü I/S• Revenue and expenses related to monetary assets and liabilities are

translated at the average exchange rate.• Expenses related to non-monetary assets and liabilities translated at

the historical exchange rate.• translation gain or loss is recorded in ISü Dividend• dividend are translated at the historical exchange rate at declare

date83



Translation of Foreign Currency Financial Statements

Balance sheet CR method TR method

ASSETS Current rate Monetary assets Current rate Current rate

Non‐monetary assets Current rate Historical ratemonetary liabilities Current rate Current rate

Non‐monetary liabilities Current rate Historical rateEquity current rate mixed

Capital

historical rate

historical rate

Retained earnings RE0+NI‐Div equity-capital-RE0

Translation adjustment CTA(OCI) I/S84




Income Statement

CR method TR method

Revenues Average rate Average rate

Expenses Average rate Average rateexcept COGS ，

depreciationand amortization

Average rate Historical rate

Dividend historical rate historical rate

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Example:Assume that interco is a Europe-based company that has the euro as its presentation currency. On 1 January 2011, Interco established a wholly owned subsidiary in Canada,on 2011.1.1,the subsidary purchased a PP&E the BS and IS of the subsidary on 31 december 2011 has shown below

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I/S

Sales 12,000

Cost of sales 9,000

Selling expenses 750

Depreciation expense 300

Interest expense 270

Income tax 500

Net income 1,180Less

dividends(12.1,2011) 350

Balance sheet, 31 December 2011

Assets D&E

Cash 980 A/P 450

A/R 900 Notes payable 3,000

Inventory 1200 Total Debt 3,450

Total CA 3080 Capital 1,500

PP&E 3000 RE 830

Less Acc Dep 300

Total Assets 5,780 Total 5780

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The exchange rate information

Date €per C$2011.1.1 0.7

Average 2011 0.75

Weighted average rate when inventory was acquired 0.742011.12.1 when dividends were declared 0.78

2011.12.31 0.8

• Inventory is measured at historical cost on a FIFO basis.• Translate CanadaCo’s Canadian dollar financial statements into euro for

consolidation purposes,use the current rate method and the temporal rate method respectively.

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Solution:•Current rate method我们知道采用Current rate method转换报表时产生的translation adjustment计入B/S。此时我们还不知道具体的translation adjustment金额，也就无法得出完整的B/S，因此，从B/S出发是走不通的。我们可以换一条路从I/S出发试一试。我们知道Current rate method中I/S的要素全部可以使用average exchange rate求出。第一步，从I/S出发NI-Div=1,180*0.75-350*0.78=612→RE

第二步，从B/S出发Total Assets:5780*0.8=4624 Total Debt 3,450*0.8=2760,equity=4624-2760=1864Capital =1,500*0.7=1050Retained earning=612CTA=equity-capital-retained earning=202

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Temporal rate method 第一步，从B/S出发。Non-monetary assets=inventory1200*0.74+PP&E2700*0.7=2778 Monetary assets=cash980*0.8 +A/R 900*0.8=1504Total assets=2778+1504=4282Liabilities CanadaCo的所有负债都是monetary的Total Liabilities= 3,450*0.8=2760Equity=Asset-liability=4282-2760=1522 capital=1500*0.7=1050RE=Equity1522-Capital 1050=472NI(折算调整后)=RE+dividend=472+350*0.78=745第二步，从I/S出发Sales12000*0.75-COGS9000*0.74-750*0.75-300*0.7-270*0.75-500*0.75=NI（折算调整前）=990NI(折算调整后)-NI（折算调整前）=745-990=-245TA（translation loss）

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Balance sheet exposure

Ø Current rate methodü Risk exposure=equityØ Temproal methodü Risk exposure=monetary asset-monetary liability

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Balance sheet exposure

Ø The temporal rate method:TA→I/S

• When using the temporal method, companies can manage their exposure to translation gain (loss) more easily than when using the current rate method. (monetary assets= monetary liabilities)

• The current rate method eliminates the balance sheet exposure when total assets equal total liabilities (no equity).

Foreign currency

Strengthens WeakensNet monetary assets

exposure Positive Negative

Net monetary liabilities exposure Negative Positive

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Translation Analytical Issues

When foreign currency becomes strengths,

Current rate method Temporal method

B/S A↑ L↑ E↑∵TA>TL，Translation Adjustment>0

A↑ L↑ E↓（net monetaryliabilityexposure）

A↑L↑E↑（net monetary asset exposure)

I/S Sales↑ expense↑ Sales↑ expense↑

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Ø Ratios analysis after translation• When foreign currency becomes strengths, under CR method.

Pure B/S ratios Pure I/S ratios

Current ratio The same Gross profit margin The same

Quick ratio The same Net profit margin The same

LTD/total capital The same

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Ø When foreign currency becomes strengths, under CR method.

Mixed B/S and I/S ratios (H<A<C)

Return on assets=NI/average assets ↓

Return on equity=NI/average equity ↓

Total asset turnover=sales/average assets ↓

Inventory turnover=COGS/average inventory ↓

Account receivableturnover=Sales/averageAR ↓

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Ø When foreign currency becomes strengths, under 2 methods.H<A<C Temporal Current rate

Current ratio lower higherQuick ratio The same The same

Inventory turnover(FIFO) higher lowerAccount receivable turnover The same The same

Fixed asset turnover higher lowerGross profit margin higher lowerNet profit margin Uncertain UncertainInterest coverage higher lower

LTD/total capital(D+E) higher lower

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Translation in a hyper inflationary economy

Ø A hyperinflationary economy is the one in which the cumulative three-year inflation rate exceeds 100%, requires an average of approximately 26% per year.

Ø US GAAP• Temporal rate method• Disappearing plant problemü When the current method is used in a hyperinflationary country, translating the

historical cost of assets at progressively weaker exchange rates causes these assets to slowly disappear from the parent company’s consolidated financial statement.

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Translation in a hyperinflationary economy

Ø IFRSü IFRS→restate, adjust non-monetary items→the current exchange rate• B/Sl Non-monetary assets and liabilities* ending price index/beginning price

indexl Equity (other than retained earnings)* ending price index/beginning price

index• I/Sl Revenue*ending price index/average price indexl Expense*ending price index/average price indexl Purchasing power gain/loss (PPGL)计入I/S.ü Monetary assets: -期初值*(Ending-beginning)/beginning-新增*(Ending-

average)/averageü Monetary debt:+number*(Ending-beginning)/beginning+新增*(Ending-

average)/average98




Ø Example:• Foreign subsidiary I/S, 2011 in foreign currency• Rent revenue 1,000• Interest (250)• Net income 750• Foreign subsidiary B/S

(In FC) 2011.1.1 2011.12.31Cash 1,000 1,750Land 9,000 9,000

Total Assets 10,000 10,750Note payable （5%） 5,000 5,000

Capital stock 5,000 5,000RE 0 750

Total D&E 10,000 10,750

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Ø The foreign country experienced significant inflation in 2011, especially the second half of the year. The inflation rate in 2011 is 100%.

Ø What amounts will this company include in its consolidate financial statements under IFRS and US GAAP?

CPI $ per FC

2011.1.1 100 1

Average 2011 125 0.8

2011.12.31 200 0.5

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Solution to 1:IFRS→restate, adjust non-monetary items→the current EX Purchasing power gain/loss (PPGL)计入I/S.第一步，restateB/S:Total assets=1750+9000*200/100=19,750Total D=5000, Equity=19750-5000=14750capital=5000*200/100=10000retained earning=NI=4750I/S:NI=750*200/125=1200PPGL =4750-1200=35504750*0.5=2375

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Purchasing power gain/loss资产类：-[1,000*（200-100）/100+750*(200-125)/125]=-1,450 负债类：+5,000*(200-100)/100=5,000Total=-1,450+5,000=3,550第二步，The current EX。B/S:Total assets=19,750*0.5=9,875 Total D=5000*0.5=2,500 Equity=10,000*0.5+4,750*0.5=7,375I/S:NI=4,750*0.5=2,375

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Solution to 2:US GAAP: the temporal method→I/S第一步，from B/S。Total assets=cash 1,750*0.5+land 9,000*1=9,875 Total D=5000*0.5=2,500 Equity=5000*1+NI9,875-2,500-(5000+NI), NI=2,375第二步，from I/S, Average EX。NI=750*0.8+TA=600+TA=2,375, TA=1,775

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The effect of tax rate

Ø Mutlinatioal corporations are subject to multiple tax jurisdictions with differing laws and tax rates.

• Effective tax rate= tax expense / pretax profit• Statutory tax rate is provided by the tax code of the home country.

Ø Changes in effective tax rate on account of foreign operations due to:

• Changes in the mix of profits from different countries• Changes in tax rates

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Sales growth and EX risk

ü For a multinational company, sales growth is driven not only by changes in P,Q .but also by changes in the EX between the presentation currency and the currency in which sales are made.

ü Growth in sales that comes from changes in P or Q is more sustainable than growth in sales comes from changes in EX.

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Summary

Ø Foreign Currency TransactionsØ Translation of Foreign Currency Financial Statements• Current rate method• Temporal rate methodØ Translation in a hyperinflationary economy• U.S.GAAP and IFRSØ The effect tax rateØ Sales growth and EX risk

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THANKS!

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Reading 16 Analysis of Financial Institutions

Introduction

ØFinancial institutionsü Systemic importance. • Inter-dependencies introduce a system-wide risk of failure,when

one of the member institutions fails—the contagion effect.ü Regulatedü Intermediaries• Provide a wide range of financial products and servicesü Facilitate asset and risk managementØGlobal Organizationsü Basel Committee on Banking Supervisionü International Association of Insurance Supervisors(IAIS)ü International Organization of Securities Commissions

(IOSCO)ü Financial Stability Board(FSB)Ø Individual Jurisdictions's Regulatory Authoritiesü US National Association of Insurance Commissioners

(NAIC)108



Basel III framework

Three pillars Ø Minimum required capital.Capital adequacy is based on risk-weighted

assets (RWA); more risky assets require a higher level of capital. Risk-weighting is specified by individual.Risk-weighting is specified by individual regulators.

ü Basel III defines a bank's capital in a tiered. Common Equity Tier 1 capital of 4.5% of RWA,minimum total Tier 1 capital of 6% of RWA, and minimum total capital of 8% of RWA.

• Tier 1 capital Common Equity Tier 1 capital：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)• Tier 2 capital：Subordinated instruments with original (i.e., when issued)

maturity of more than five years.109



Basel III framework

Ø liquidity• Basel III specifies that a bank should hold enough liquid assets to meet

demands under a 30-day liquidity stress scenario.Ø Stable fundingü tenor of the bank’s deposits

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Mega Bank is regulated by the Central Bank of Zima. Per the central bank rules, the following risk weightings are applied to the bank‘s assets.

An Analysis of Mega Bank’s balance sheet for 20X8 reveals the following.

Calculate Mega Bank’s RWA.

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Mega Bank’s RWA for 20X7 and 20X8 were $4,700,000 and $5,175,000, respectively. An analysis of bank’s capital for the two years reveals the following information.

1. Determine the Common Equity Tier 1 capital ratio, Tier 1 capital ratio and total capital ratio for both years.2.Comment on capital adequacy for Mega Bank.

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2. Mega Bank’s Common Equity Tier 1 ratio is less than Basel III guideline of 4.5%.Furthermore, it has worsened from 20X7 to 20X8. Given that this is the most importantcomponent of capital, it should be a cause for concern for the bank’s regulators. The bank’s total Tier 1 ratio was above the Basel III guideline of 6% in 20X7, but it has fallen below the guideline for 20X8. The total capital ratio is above the Basel III guideline of 8% for 20X7 but again has fallen short in 20X8.

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Basel III framework

Which of the following is least likely to be recommended by the Basel III framework?A. Minimum percentage of risk-weighted assets that needs to be held as capital.B. Rate spread earned on assets over the deposit crediting rate should be positive.C. The minimum required stable funding level to cover one-year time-horizon liquidity needs.

Solution:B The three pillars of Basel III framework are minimum capital requirements (as a proportion of risk-weighted assets), minimum liquidity, and stable funding. While a positive spread on deposit is always needed for a bank to be profitable, it is not arecommendation of the Basel III framework.

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Analyzing a Bank

Ø The CAMELS ApproachØ Componentsü Capital adequacyü Asset quality• Bank assets include loans (Amortised cost) and investments in

securities• Allowance for loan losses or provision for loan losses• Under U.S. GAAP, equity investments are carried at fair value

through profit or loss• Under U.S. IFRS, equity investments are carried at FVPL or FVOCI.ü Management Capabilitiesü Identification and control of different types of risk


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Analyzing a Bank

Ø Earnings ü net interest incomeü service incomeü trading income( most volatile )• Both IFRS and U.S.GAAP use the concept of a fair value hierarchy

based on types of inputs used in determining the fair value of financial assets.

fair value hierarchyü Level 1 inputs are quoted market prices of identical assets. ü Level 2 inputs are observable but not quoted prices of identical

assetsü Level 3 inputs are nonobservable and hence subjective,may be

derived from models


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Analyzing a Bank


Under current accounting standards, equity securities in a bank’s portfolio are most likely shown on the balance sheet at:A. Fair value.B. Fair value under US GAAP and fair value or amortized cost under IFRS.C. Fair value under IFRS and fair value or amortized cost under US GAAP.

Solution:AEquity securities are carried on the balance sheet at fair value (and unrealized gains are shown in the income statement) under current U.S. GAAP standards. Under IFRS, equity is also carried at fair value on the balance sheet, but unrealized gains can be in OCI (fair value through OCI classification) or in the income statement (fair value through profit or loss classification).

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Analyzing a Bank

Ø Liquidity position• The Liquidity Coverage Ratio (LCR)

• The Net Stable Funding Ratio (NSFR)

• Concentration of funding and maturity mismatchØ Sensitivity to market riskü security pricesü Currency valuesü interest rates


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Analyzing a Bank


Based on the information below, which bank has the highest liquidity risk in a stress scenario?

A. Beta.B. Delta.C. Charlie Solution:C Liquidity risk in a stress scenario is measured by LCR. Charlie has the lowest LCR and hence the highest liquidity risk.

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Other Factors Relevant to Analysis of a Bank

Ø Banking-Specific Analytical Considerations Not Addressed by CAMELS

ü Government support. ü Government Ownershipü Bank Missionü Corporate culture• Diversity of a bank's assets• Accounting restatements • Management compensation• Speed with which a bank adjusts its loan loss provisions relative to

actual loss behavior.Ø General factors that are relevant to analysis of any company (not just

banks)ü Competitive environmentü Off-balance-sheet items（VIE，lease，contingent liability,Benefit

plans,assets under management）• Segment information• Currency exposure


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Other Factors Relevant to Analysis of a Bank


Government ownership of a significant stake in a bank is most likely to indicate that: A. there is a high likelihood of government support in the event of failure. B. required liquidity ratios are lower than for privately owned banks. C. the ratio of Common Equity Tier 1 to risk-weighted assets is high.

Solution:A Government ownership of part or all of a bank is an indication of implied government backing of the bank should the bank’s capital prove inadequate to absorb losses.

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Analyzing an Insurance Company

Ø Property and Casualty Insurance CompaniesØ Profitabilityü Premium income is usually the highest source of income for a

P&C insurerü Reinsure some risks to diversify their risksü Property insurance covers specific assets against loss due to

insured eventsü Casualty insurance (also called liability insurance) protects

against a legal liability due to the occurrence of a covered eventü Multiple peril policy


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Ø Ratio

ü Loss and loss adjustment expense ratio = (Loss expense + Loss adjustment expense)/Net premiums earned. This ratio indicates the degree of success an underwriter has achieved in estimating the risks insured. The lower the ratio, the greater the success.


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Ø Ratioü Underwriting expense ratio = Underwriting expense/Net premiums written. This ratio measures the efficiency of

money spent in obtaining new premiums. A lower ratio indicates higher success.ü Combined ratio = Loss and loss adjustment expense ratio + Underwriting expense ratio. This ratio indicates the

overall efficiency of an underwriting oper_x0002_ation. A combined ratio of less than 100 is considered efficient.ü Dividends to policyholders (shareholders) ratio = Dividends to policyholders (shareholders)/Net premiums earned.

This ratio is a measure of liquidity, in that it relates the cash outflow of dividends to the premiums earned in the same period.

ü Combined ratio after dividends = Combined ratio + Dividends to policyholders (shareholders) ratio. This ratio is a stricter measure of efficiency than the ordinary combined ratio, in that it takes into account the cash satisfaction of policyholders or shareholders after consideration of the total underwriting efforts.

ü Investment Returns• investment return ratio = total investment income ÷ invested assets


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Ø Liquidityü Liquidity is an important consideration for P&C insurers as

they stand ready to meet their claim obligations. ü One way to gauge the liquidity of the investment portfolio is

to look at their fair value hierarchy reporting.Ø Capitalization• no global minimum capitalization standards


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Ø Life&Health Insurance Companiesü Revenue diversification• The proportion of income generated from premiums,investments, and fees can

vary over time and among insurers.ü Earnings characteristicsü Affect the value of the future liabilities due to policyholders Actuarial assumptions• total benefits paid ÷ net premiums written and deposits.• commissions and expenses ÷ net premiums written and depositsü Investment returns.• L&H insurers have a longer float period than P&C insurers, so investment returns

are a key component of the insurer’s profitability.ü Liquidity• The liquidity needs of L&H insurers are generally fairly predictable.Hence, keeping

excess liquidity isnot as much of a concern for L&H insurers compared to P&C insurers.

ü Capitalization• no global minimum capitalization standards


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1.Relative to P&C insurers, L&H insurers are most likely to have:A. a longer contract period.B. lumpier claims.C. a higher liquidity risk

Solution: A The contract period is typically much longer for L&H insurers than for P&C insurers.

2. For a single insurer, a combined ratio of greater than 100% would most accurately indicate:A. an underwriting loss.B. an underwriting profit.C. high liquidity

Solution:A For a single insurer, a combined ratio in excess of 100% indicates a loss. 127



128

THANKS!

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Reading17 Evaluating Quality of Financial Reports

FINANCIAL REPORT QUALITY

Ø Reporting quality• High-quality reporting provides decision-useful information (relevant and faithful, unbiased

accounting choice)• Low-quality reporting impedes assessment Ø Earnings qualityØ Financial reports quality spectrum(high to low)Ø 1. GAAP compliant and decision-useful, high-quality earnings.Ø 2. GAAP compliant and decision-useful, low-quality earnings.Ø 3. GAAP compliant but not decision-useful (biased choices).Ø 4. Non-compliant accounting.Ø 5. Fraudulent accounting.

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Ø Biased accountingü Aggressive financial reportü Conservative financial reportØ Mechanisms to misstate profitabilityü Bill and hold salesü Channel stuffingü Operating cash flow lower than operating income.ü High proportion of revenue is received in final quarterü Executive compensation largely tied to financial resultsØ Mechanisms to misstate assets/liabilitiesü Reclassification from current to non-currentü High goodwill relative to total assets.ü Use of special purpose entitiesü Large off-balance-sheet liabilitiesØ Mechanisms to overstate operating cash flowsü Managing activities to affect cash flow from operations (e.g., stretching payables)ü Increase in payables combined with decreases in inventory and receivables

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Ø Business combination—acquisition method accountingü Cash acquisitions are reflected in cash flow from investing

activities. ü Stock acquisitions provide an incentive for the acquiring company

management to pursue aggressive accounting so as to inflate their stock price prior to acquisition to fetch an attractive price at acquisition.

ü Acquiring companies often underestimate the value of identifiable net assets—thereby overestimating goodwill on acquisition.

ü Since goodwill is not amortized，the effect of overestimating goodwill and underestimating the value of identifiable assets is to increase future reported profits.Such inflated goodwill will eventually have to be written down as part of impairment testing but such losses can be timed.

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Ø Earning qualityü A high level of earnings (meets the required return on investment) as

well as sustainability of earnings.ü High-quality earning is based on high-quality reporting.ü High-quality earnings but low-quality reporting is impossible.ü High-quality reporting but low-quality earnings is possible

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Quantitative tools to evaulating earning qualityØ The Beneish Modelü M-score, determines the probability of earnings manipulation 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)• Days sales receivable index (DSRI)=(Receivablest/Salest)/(Receivablest-1/Salest-1)• Gross margin index (GMI)=Gross margint-1/Gross margint• Asset quality index (AQI)=[1-(PPEt+CAt)/TAt]/ [1-(PPEt-1+CAt-1)/TAt-1]• Sales growth index (SGI)=Salest/Salest-1• Depreciation index (DEPI)=Depreciation ratet-1/Depreciation ratet ; depreciation rate=

Depreciation/(Depreciation + PPE)• Sales, general and administrative expenses index (SGAI)=(SGAt/Salest)/ (SGAt-1/Salest-1)• Accurals=(Income before extraodinary items – cash from operations)/ total assets.• Leverage index (LEVI)=Leveraget/leveraget-1; leverage= Debt/ Equity.• A higher M-score indicate higher level of earning manipulation.M-score > –1.78 (i.e., less negative) indicates

a higher-than-acceptable probability of• earnings manipulation.ü Limitations• Relies on accounting data, which may not reflect economic reality.• The predictive power of the Beneish model is decreasing.

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Quantitative tools to evaulating earning quality

Ø Altman Model• Z-score, the probability of bankruptcy.• Z=1.2A+1.4B+3.3C+0.6D+1.0E• A = WC / TA• B = RE / TA• C = EBIT / TA• D = MV of Equity / BV of Debt• E = Revenue / TA• Higher Z-score, lower probability of bankruptcy.ü Limitation• One-period static model.• Depends on accounting data, not market data

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Quantitative tools to evaulating earning quality

Ø Gauge earnings persistence:ü Earnings(t+1) =α+β1 earnings(t )+ εü Accruals=non-discretionary accruals + discretionary accrualsü Earnings(t+1) =α+β1 earnings(t )+β2 Accurals(t )+ εü Higher β1 indicates higher persistence of earnings.• non-discretionary accruals includes credit sales growth• Red flagsü Negative cash flow and positive net incomes.Ø Mean reversion in earningsü Earnings at extreme levels tend to revert back to normal levels over time. earnings are largely comprised of accruals, mean reversion will occur faster,

even more so when the accruals are largely discretionary.

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Evaluation balance sheet quality

Ø Completenessü Capitalized operating lease classificationü Recording purchase contract obligations of take-or-pay contractsØ Unbiased Measurementü Value of the pension liability ü Value of investment in debt or equity of other companies for which

a market value is not readily available.ü Goodwill value (subjectivity in impairment testing).ü Inventory valuation (subjectivity in testing for impairment).ü Impairment of PP&E and other assets.Ø Clear Presentationü Financial statements.ü Auditor’s reportü Notes to financial statementsü Management Discussion and Analysis (MD&A)ü SEC Form‘NT’ü Financial press 137



Evaluation cash flow quality

Ø High- quality cash flow means the reported cash flow was high

Ø High-quality cash flow is characterized by positive OCF that is derived from sustainable sources and is adequate to cover capital expenditures, dividends, and debt repayments

Ø High-quality OCF is characterized by lower volatility than that of the firm’s peers. Significant differences between OCF and earnings, or differences that widen over time, can be an indicator of earnings manipulation.

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Financial reporting analysis

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Reading18 Integration of Financial Statement Analysis Techniques

Framework for analysis

Steps Inputs Outputs

1. Establish theobjectives

Perspective of the analystCommunication with client or supervisor

Institutional guideline

Statement of the purposeQuestions list

ReportTimetable and budgeted for

completion

2. Collect data Financial statementCommunication with related personal Organized financial information

3. Process data Data from step 2

Adjusted financial statementCommon-size statement

RatiosForecasts

4. Analyze data Data from step 2 and step 3 Results5. Conclusion Results and published reports Recommendations6. Follow-up Update information Update information

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Framework for analysis

When applying the financial analysis framework, which of the following is the best example of output from processing data?A. A written list of questions to be answered by management.B. Audited financial statements.C. Common-size financial statements

Solution:C Common-size financial statements are created in the data processing step of the framework for financial analysis.

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DuPont analysis for ROE

Ø DuPont analysisØ three steps method

•

• DuPont analysis(extended equation)• five steps method

• Interest burden: EBT/EBIT.• Operating margin: EBIT/Revenue.• Asset turnover: Revenue/assets.• Leverage: Asset/Equity.


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Accruals ratio

Ø Balance sheet approachü AccrualsB/S= NOAEND-NOABEG• NOA=Operating assets – operating liabilities.• Operating assets = total assets – cash, cash equivalents and marketable securities.• Operating liabilities = total liabilities – total debt

Ø Cash flow statement approachü AccrualsCF=NI–CFO-CFI

Although both accruals ratios are conceptually equivalent , their results can differ because of acquisitions and divestitures, exchange rate gains and losses, and inconsistent treatment of specific items on the balance sheet and on the cash flow statement.


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Accruals ratio


Ø Cash generated from operations (CGO)ü CGO = EBIT + non-cash charges − increase in working capital

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Financial reporting analysis CFA二级基础班

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