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Financial Reporting and
Analysis
2019 Instructor: Jackie & Vivian
1

Brief Introduction
Topic weight:
Study Session 1-2
Ethics & Professional Standards
10%-15%
Study Session 3
Quantitative Analysis
5%-10%
Study Session 4
Economics
o5%-10% 10%-15%
Study Session 5-6
Financial Reporting and Analysis
Study Session 7-8
Corporate Finance
5%-10%
Study Session 9-11
Equity Valuation
10%-15%
Study Session 12-13
Fixed Income
10%-15%
Study Session 14
Derivative Investment
5%-10%
Study Session 15
Alternative Investment
5%-10%
Study Session 16-17
Portfolio Management
5%-15%
Weights: 100%
2

Contents
Content:
➢ Study Session 1: FINANCIAL REPORTING AND ANALYSIS (1)
• Reading 14: Intercorporate Investments★★★
• Reading 15: Employee Compensation: Post-Employment and Share-
Based★★★
• Reading 16: Multinational Operations★★★
• Reading 17: Analysis of Financial Institutions ★★
➢ Study Session 2: FINANCIAL REPORTING AND ANALYSIS (2)
• Reading 18. Evaluating Quality of Financial Reports ★★
• Reading 19: Integration of Financial Statement Analysis Techniques★
3

Brief Introduction
考纲对比:
➢ 与2018年相比，2019年FRA的考试权重调整为10% ~
15%。
➢ 与2018年相比，2019年的考纲增加了一个章节:
Reading 17 Analysis of Financial Institutions。
4

Brief Introduction
学习建议:
➢ 财报质量的考查可能会穿插一级财务报告与分析的知识点 ，在学习二级新知识点的同时应适当复习一级财务报告与 分析的重要知识点;
➢ 一定要在理解知识点的基础上通过做题达到熟练运用的目 的。
➢ 推荐使用官方教材正文中的例题、课后习题和官方历年模 考题复习巩固知识点。
5

Intercorporate Investments
Investments in Financial Assets
Tasks:
➢ Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for financial assets.
➢ Distinguish between IFRS and US GAAP in the classification, measurement, and disclosure of financial assets.
6

Intercorporate Investments
Definition of intercorporate investments
➢ Intercorporate investments in marketable securities are categorized as follows:
✓ Investments in financial assets (has no significant influence) ✓ Investments in associates (has significant influence)
✓ Business combinations (has control over the investee firm) ✓ Joint ventures (the right of control is shared by entities)
7

Intercorporate Investments
The classification of categories
➢ Percentage of ownership is typically used to determine the appropriate category. However, the ownership percentage is only a guideline.
➢ Ultimately, the category is based on the investor’s ability to influence or control the investee.
8

Categorization of Investment
Financial Assets
Associates
Business Combination
Joint Ventures
Degree of influence
No significant
Significant
Control
Shared control
Typical percentage of interest
< 20%
20% - 50%

50%
Varies
Term of investee
N/A
Associate
Subsidiary
N/A
Accounting treatment
✓ HTM
✓ AFS
✓ Fair value
through Profit / Loss
Equity method
Acquisition method
Equity method
9

Financial Assets
Definition of financial assets
➢ The classification below only applies to equity or debt investment with no significant influence (percentage of interests < 20%) :
• HTM is only for debt securities
• Available for sale security (AFS)
• Fair value through P/L (including trading securities &
designated at fair value)
➢ GAAP and IFRS are the same about the classification.
10

Financial Assets
Held-to-maturity investments
➢ Held-to-maturity investments are investments in financial assets with fixed or determinable payments and fixed maturities (only debt securities) that the investor has the positive intent and ability to hold to maturity.
11

Financial Assets
Held-to-maturity investments(Cont.)
➢ Initial recognition (similar under IFRS & US GAAP)
• IFRS: recognized at fair value.
• US GAAP: recognized at initial price paid.
➢ Held-to-maturity securities are reported on the balance sheet at amortized cost.
• Amortized cost is simply the present value of the
remaining cash flow (coupon & face value).
12

Financial Assets
Fair value through profit and loss
➢ Held-for-trading securities (Equity & Debt)
• Securities acquired with the intend to sell them in the near
term. (usually less than 3 months)
• Reported on the balance sheet at fair value.
• Both realized and unrealized gain and loss are recognized
in the income statement. ➢ Designated at fair value
• Designating financial assets at fair value regardless the holding intention.
• The treatment is similar to that of trading securities.
13

Financial Assets
Available for sale securities
➢ Not classified as held to maturity and fair value through profit and loss securities.
➢ Available for sale securities are reported on the balance sheet at fair value.
➢ Realized gain and loss are recognized on income statement.
➢ Unrealized gain and loss are recognized on equity (OCI).
➢ Accounting treatment of available for sale securities when
foreign exchange rate is changing.
• Next slide
14

Available for Sale Securities
Foreign exchange rate changes
➢ Debt:
• US GAAP: All change in fair value of available for sale
investments is recognized in OCI.
• IFRS:
✓ Recognize foreign exchange gain or loss in income
statement.
✓ Recognize other changes in fair value in OCI.
➢ Equity:
• Recognize all changes of fair value in OCI.
(Both US GAAP and IFRS)
15

Summary of Classification of Financial Assets
Held-to-Maturity
Fair value through profit or loss
Available-for-Sale
Balance Sheet
Amortized cost
Fair value
✓ Fair value ✓ Unrealized
G/L (OCI- Equity)
Income Statement
✓ Interest (including
amortization) ✓ Realized G/L
✓ Interest & Dividends
✓ Realized G/L ✓ Unrealized G/L
✓ Interest & Dividends
✓ Realized G/L
16

Example
Accounting For HTM Bonds at a Discount
Ledesma Corp bought a 3-year $1,000 par value bond with an annual coupon of 10% at $951.96. The effective interest rate, which equates with the market interest rate, is 12%.
Asset on BS
Interest Income
Coupon Received
Interest Amortisation
Year 1
951.96
114.24
100
14.24
Year 2
966.20
115.94
100
15.94
Year 3
982.14
117.86
100
17.86
Bond
1,000
redemption
17

Example
Accounting For HTM Bonds at a Premium
Illiquid Corporation bought a 3-year $1,000 par value bond with a coupon of 20% at $1,131. The effective interest rate, which equates with the market interest rate, is 14.33%.
Asset on BS
Interest Income
Coupon Received
Interest Amortisation
Year 1
1,130.88
162.05
200
-37.94
Year 2
1,092.93
156.62
200
-43.39
Year 3
1,049.55
150.40
200
-49.60
Bond
1,000
redemption
18

Example
A company purchased a 9% bond with a face value of $100,000 for $96,209 to yield 10%. The coupon payments are made annually at year end. The fair value of the bond at the end of the year is $98,500.
Determine the impact on the firm’s B/S and I/S if the bond investment is classified as held-to-maturity, fair value through profit or loss and available- for-sale.
19

Example
Held-to-maturity
➢ The balance sheet value is based on amortized cost.
➢ At year-end, the company recognizes interest revenue of $9,621
($96,209 × 10%). — Income statement
➢ At year-end, the bond is reported on the balance sheet at
$96,830 ($96,209 + $9,621 - $9,000). — Balance sheet
20

Example
Fair value through profit and loss
➢ The balance sheet value is based on fair value of $98,500.
➢ At year-end, the company recognizes interest revenue of $9,621
($96,209 × 10%). — Income statement
➢ The unrealized gain of $1,670 ($98,500 - $96,209 - $621) are
recognized in the income statement.
21

Example
Available for sale
➢ The balance sheet value is based on fair value of $98,500.
➢ At year-end, the company recognizes interest revenue of $9,621
($96,209 × 10%). — Income statement
➢ The unrealized gain of $1,670 ($98,500 - $96,209 - $621) are
recognized in other comprehensive income. (OCI)
22

Summary
➢ Importance: ☆☆ ➢ Content:
• The classification, measurement of financial assets under both IFRS and US GAAP.
➢ Exam tips:
• 定性、定量掌握Financial Assets的初始确认的原则、后续
计量的方法。
• 掌握IFRS和USGAAP对FinancialAssets计量的异同点。
23

Intercorporate Investments
Reclassification of Financial Assets
Tasks:
➢ Describe the measurement (reclassification) of investments in financial assets under IFRS.
➢ Distinguish between IFRS and US GAAP in measurement (reclassification) of investments in financial assets.
24

Reclassification of Financial Assets
IFRS
➢ IFRS typically does not allow reclassification of investments into or out of the designated at fair value category.
➢ Reclassification of investments out of the held-to-trading category is severely restricted under IFRS.
25

Reclassification of Financial Assets
IFRS (Conts)
➢ Debt securities initially designated as available-for-sale may be reclassified to held-to-maturity if a change in intention or ability has occurred.
➢ Held-to-maturity securities can be reclassified as available-for- sale if the holder no longer intends or is no longer able to hold the debt to maturity.
26

Reclassification of Financial Assets
U.S. GAAP
➢ U.S. GAAP allows reclassifications of securities between all categories when justified.
➢ Fair value of the security is determined at the date of transfer.
➢ The treatment of unrealized holding gains and losses on the
transfer date depends on the initial classification of the security.
27

Summary - IFRS
Transfer from
Transfer to
Accounting Treatment
Designated at fair value
Any type of Investments
Prohibited
Hold-for- Trading
Any type of Investments
Severely restricted
Hold-to- Maturity
Available-for- Sale
Remeasure at fair value at transfer date, difference between carrying value and fair value reported in O.C.I.
Available-for- Sale (Debt)
Hold-to- Maturity
Remeasure at fair value at transfer date as amortized cost.
O.C.I. bal. and difference between amortized cost and maturity value should amortized in I/S during remaining life of debts using the effective interest method.
28

Summary – US GAAP
Transfer from
Transfer to
Accounting Treatment
Hold-for- Trading
Available-for- Sale
Unrealized G/L (difference between carrying value and current fair value) should be reported in I/S.
Available-for- Sale
Hold-for- Trading
Accumulated amount in OCI should be recognized in I/S on the date of transfer.
Hold-to- Maturity
Available-for- Sale
Unrealized G/L (difference between fair value and amortized cost) reported in O.C.I.
Available-for- Sale (Debt)
Hold-to- Maturity
Accumulated amount in OCI should be amortized over remaining life of the security as an adj. of interest income as the same manner as premium or discount.
29

Summary
➢ Importance: ☆☆ ➢ Content:
• The treatment of reclassification of investments in financial assets under both IFRS and US GAAP.
➢ Exam tips:
• 定性掌握IFRS和USGAAP对于InvestmentinFinancialAssets
重分类的计量方法。
30

Intercorporate Investments
Impairment of Financial Assets
Tasks:
➢ Describe the measurement (impairment) of investments in financial assets under IFRS. ➢ Distinguish between IFRS and US GAAP in
measurement (impairment) of investments in financial assets.
31

Impairment of Financial Asset
Both U.S. GAAP and IFRS
➢ U.S. GAAP and IFRS require that held to maturity and available for sale securities be evaluated for impairment at each reporting period.
➢ It’s not necessary for fair value through profit and loss securities because declines in their value are recognized on the income statement as they occur.
32

Impairment of Financial Asset
Under IFRS (Impair indication)
➢ For debt security, impairment is indicated if at least
one loss events has occurred, and its effect on the
security’s future cash flows can be estimated reliably. ✓ Losses due to occurrences of future events
(regardless of the probability of occurrence) are not recognized.
33

Impairment of Financial Asset
Under IFRS (Impair indication)
➢ For the debt security, the loss events are including:
✓ The issuer experiences significant financial difficulty; ✓ Default or delinquency in interest or principal
payments;
✓ The borrower encounters financial difficulty and
receives a concession from the lender as a result;
and
✓ It becomes probable that the borrower will enter
bankruptcy or other financial reorganization.
34

Impairment of Financial Asset
Under IFRS (Impair indication)
➢ For the debt security, the following events are not by
itself evidence of impairment:
✓ The lack of an active market;
✓ A downgrade of an entity’s credit rating or a decline
in fair value of a security below its cost or amortized cost.
35

Impairment of Financial Asset
Under IFRS (Impair indication)
➢ For the equity security, impairment is indicated if at
least one loss events has occurred:
✓ Significant changes in the technological, market, economic, and/or legal environments that adversely affect the investee and indicate that the initial cost of the equity investment may not be recovered.
✓ A significant or prolonged (持续性的) decline in the fair value of an equity investment below its cost.
36

Impairment of Financial Asset
Under IFRS (Measurement of impairment)
➢ Impairment of held to maturity securities
✓ Impaired if its carrying value > PV of cash flow
(expected permanently)
✓ Impairment loss is recognized on income statement.
➢ Reversal
✓ If the recovery can be attributed to an event (eg:
credit upgrade), the impairment loss can be reversed.
37

Impairment of Financial Asset
Under IFRS (Measurement of impairment) ➢ Impairment of available for sale securities ✓ Impaired if its carrying value > fair value
✓ Impairment loss is recognized on income statement.
➢ Reversal
✓ Impairment losses on AFS debt securities can be
reversed if a subsequent increase in fair value can be objectively related to an event occurring after the impairment loss was recognized in profit or loss.
✓ Impairment losses on AFS equity securities cannot be reversed through profit or loss.
38

Impairment of Financial Asset
Under IFRS (Measurement of impairment)
➢ Impairment of available for sale securities
✓ Cumulative loss in OCI is reclassified to income
statement.
• Cumulative loss = Acquisition cost – current fair
value – impairment loss that has previously been recognized in income statement.
39

Impairment of Financial Asset
Under U.S. GAAP
➢ A security is considered impaired if its decline in value is determined to be other than temporary. For both held to maturity and available for sale securities, the write down to fair value is treated as a realized loss. (recognized on the income statement).
➢ A subsequent reversal of impairment losses is not allowed.
✓ For ASF securities (both debt and equity), subsequent changes
in fair value are treated as unrealized gains or losses and included in OCI.
40

Summary
➢ Importance: ☆☆ ➢ Content:
• The treatment of impairment of investments in financial assets under both IFRS and US GAAP.
➢ Exam tips:
• 掌握IFRS和US GAAP对于Investment in Financial Assets
重分类的计量方法。
41

Intercorporate Investments
Investment in Financial Assets: IFRS 9
Tasks:
➢ Describe the classification, measurement and reclassification of investment in financial assets under IFRS 9.
42

IFRS 9 (New Standards)
IFRS 9 (New Standards)
➢ IFRS 9 does away with the terms held for trading, available for sale, and held to maturity. Instead, the three classifications are:
• Amortized cost
• Fair value through profit or loss (FVPL)
• Fair value through other comprehensive income
(FVOCI).
43

IFRS 9 (New Standards)
IFRS 9 (New Standards)
➢ Amortized cost (Debt only), 2 criteria:
• Business model test: Debt securities are being held to collect contractual cash flow.
• Cash flow characteristic test: The contractual cash flows are solely payments of principal and interest on principal.
44

IFRS 9 (New Standards)
IFRS 9 (New Standards) ➢ FVPL (Debt & Equity)
• Debt: Held for trading or if recognized as amortized cost will results in an accounting mismatch.
• Equity: Held for trading must be classified as FVPL; Others may be classified as either FVPL or FVOCI, irrevocable.
➢ FVOCI (Debt & Equity)
• Same as available for sale securities.
45

Summary of IFRS 9
46

Summary
➢ Importance: ☆ ➢ Content:
• IFRS 9对Financial Assets的分类标准和计量方法。 ➢ Exam tips:
• 主要考查定性的概念及辨析。
47

Intercorporate Investments
Investment in Associates
Tasks:
➢ Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for Investment in Associates.
➢ Distinguish between IFRS and US GAAP in the classification, measurement, and disclosure of Investment in Associates.
48

Definition of Associates
Definition of Associate
➢ When a company holds 20% - 50% of the voting rights of an associate, it is presumed that the company has significant influence, but not control, over the investee’s business activities.
• Representation on the board of directors
• Participation in the policy-making process
• Material transactions between the investor and the investee
• Interchange of managerial personnel
• Technological dependency
49

Equity Method
Equity Method of Accounting
➢ The equity investment is initially recorded on the investor’s balance sheet at cost. In subsequent periods, the carrying amount of the investment is adjusted to recognize the investor’s proportionate share of the investee’s earnings or losses, and these earnings or losses are reported in income.
• Dividends or other distributions received from the investee
are treated as a return of capital and reduce the carrying
amount of the investment and not reported in the I/S.
• One – line consolidation.
50

Equity Method
Equity Method的会计处理 – 规律表:
Ref.
Items
B/S - Investment
I/S - Equity Earning
1
Purchase Price
Cash ; Inv
N/A
2
% Dividend
Cash ; Inv
N/A
3
% Net Income
Inv
4
% Depreciation =(FV-BV)/N
Inv
5
% RPT Unrealized Profit
Inv
51

Example
Equity Method of Accounting
➢ December 31, 20X5, Company A invests $1,000 in return for 30% of the common shares of Company B.
• During 20X6, Company B earns $400 and pays dividends of $100.
➢ Calculate the effects of the investment on Company A’s balance sheet, income statement and cash flow for 20X6.
52

Example
Equity Method of Accounting (Answer)
➢ Recognize $120 ($400×30%) in the I/S from its proportionate share of the net income of Company B.
➢ Increase its investment account on the balance sheet by $120 to $1,120 to reflect its proportionate share of the net assets of B.
➢ Receive $30 ($100×30%) in cash dividends from Company B and reduce its investment in Company B by that amount to reflect the decline in the net assets of Company B due to the dividend payment.
• At the end of 20X6, the book value of the investment on Company
A’s B/S = $1,000 + $120 - $30 = $1,090
53

Equity Method
Investment Costs That Exceed the Book Value of the Investee
➢ Acquisition cost is initially recognized as investment in associate, and comprises of two parts:
• Fair value of the net assets acquired.
• Goodwill (Not amortized but need to test for impairment)
➢ The difference between fair value and book value of the net assets acquired will adjust the I/S of investor’s equity income.
• Not simply equals to the net income earned by investee
multiplied by percentage of interests owned.
54

Equity Method
Investment Costs That Exceed the Book Value of the Investee
Goodwill is renewed for impairment on a regular basis.
This part is amortized to the investee’s profit or loss over economic lives.
55

Example
Investment Costs That Exceed the Book Value of the Investee
➢ At the beginning of the year, A Company purchased 30% of B Company for $80,000. Net asset of company B in book value is $200,000. On the acquisition date, the book value of B’s assets and liabilities were the same except for B’s equipment, which had a book value of $25,000 and a fair value of $75,000 on the acquisition date. B’s equipment is depreciated over ten years using the straight – line method. At the end of the year, B reported net income of $100,000 and paid dividends of $60,000.
56

Example
Question A: Calculate the goodwill
➢ Goodwill = Purchase price – Fair value of the net assets
= Purchase price – (Book value of the net assets +
Appreciation of the equipment)
=$80,000 – [$200,000 x 30% + ($75,000 FV - $25,000 BV)
x 30%] =$5,000
57

Example
Question B: Calculate Company A’s equity income at the end of the year from its investment in Company B.
➢ Equity income = Proportionate share of B’s net income – Additional depreciation from excess of purchase price allocated to B’s equipment.
➢ Equity income = ($100,000 x 30%) – (Excess / 10) = $28,500 • Excess = ($75,000 - $25,000) x 30% = $15,000
58

Example
Question C: Calculate the investment in Company B that appears on Company A’s year-end balance sheet.
➢ Investment balance at end of year = Investment balance at beginning of year + Equity income – Dividends pay out
➢ Investment = $80,000 + $28,500 (Equity income) – ($60,000 x 30%) = $90,500
59

Fair Value Option
➢ Both IFRS and US GAAP give the investor the option to account for their equity method investment at fair value.
• Both standards require that the election to use the fair
value option occur at the time of initial recognition and is
irrevocable.
• The investment is reported at fair value with unrealized
gains and losses arising from changes in fair value as well as any interest and dividends received included in the investor’s profit or loss.
60

Fair Value Option
➢ Both IFRS and US GAAP give the investor the option to account for their equity method investment at fair value. (Cont.)
•
Under the fair value method, the investment account on the investor’s balance sheet does not reflect the investor’s proportionate share of the investee’s profit / loss or dividends.
In addition, the excess of cost over the fair value of the investee’s identifiable net assets is not amortized, nor is goodwill created.
•
61

Summary
➢ Importance: ☆☆☆ ➢ Content:
• The classification, measurement of investment in associates under both IFRS and US GAAP.
• Equity Method (B/S，I/S的相关处理) ➢ Exam tips:
• 定性掌握关联企业投资的判定标准;
• 定量掌握关联企业投资的计量方法——Equity Method;
• 简单了解Fair Value Option。
62

Intercorporate Investments
Adjustments of Equity Investment
Tasks:
➢ Describe and Distinguish the impairment for investment in associates under both IFRS and US GAAP.
➢ Describe the transactions with associates under equity method for investment in associates.
63

Impairment of Equity Investment
IFRS
➢ The entire carrying amount of the investment is tested for impairment by comparing its recoverable amount with its carrying amount.
• Recoverable amount of an asset is the higher of its value
less costs to sell and its value in use.
➢ The impairment loss is recognized on the income statement, and the carrying amount of the investment on the balance sheet is either reduced directly or through the use of an allowance account.
64

Impairment of Equity Investment
US GAAP
➢ If the fair value of the investment declines below its carrying value and the decline is determined to be permanent, an impairment loss to be recognized on the income statement and the carrying value of the investment on the balance sheet is reduced to its fair value.
➢ Both US GAAP and IFRS prohibit the reversal of impairment losses even if the fair value later increases.
65

Transactions with Associates
Upstream ( associate to investor )
➢ The profit on the intercompany transaction is recorded on the associate’s income statement.
• The investor’s share of the unrealized profit is thus
included in equity income on the investor’s income
statement.
➢ Investor must reduce its equity income of investee by
investor’s proportionate share of the unconfirmed profit.
• Unconfirmed profit means goods have not been used or
sold by the investor.
66

Example of Upstream Transaction
Upstream ( associate to investor )
➢ Suppose that Investor owns 30% of Investee. During the year, Investee sold goods to Investor and recognized $15,000 of profit from the sale. At year end, half of the goods purchased from Investee remained in Investor’s inventory.
➢ Investor must reduce its equity income by $2,250 • ($15,000 x 50%) x 30% = $2,250
➢ Once the inventory is sold by Investor, $2,250 of equity income will be recognized.
67

Transactions with Associates
Downstream ( investor to associate )
➢ The investor has recognized all of the profit in its income statement.
➢ The investor must eliminate the proportionate share of the profit that is unconfirmed.
68

Example of Downstream Transaction
Downstream ( investor to associate )
➢ Suppose that Investor owns 30% of Investee. During the year, Investor sold $40,000 of goods to Investee for $50,000. Investee sold 90% of the goods by year – end.
➢ Investor’s profit is $10,000 ($50,000 sales - $40,000 COGS)
➢ 10% of the profit remains in Investee’s inventory.
➢ Investor must reduce its equity income by the proportionate share of
unconfirmed profit:
• $10,000 profit x 10% unconfirmed amount x 30% = $300
• Once Investee sells the remaining inventory, Investor can
recognized $300 of profit.
69

Analytical Issues For Equity Method
➢ Analysts should question whether the equity method is appropriate
• Significant influence or not
➢ There can be significant assets and liabilities of the investee that
are not reflected on the investor’s balance sheet, which will
significantly affect debt ratios.
➢ Net margin ratios could be overstated because income for the
associate is included in investor net income but is not specifically
included in sales.
➢ Finally, the analyst must consider the quality of the equity
method earnings.
70

Summary
➢ Importance: ☆☆☆ ➢ Content:
• Impairment (US GAAP & IFRS)
• Transactions with Associates (upstream & downstream) ➢ Exam tips:
• 掌握Equity Method减值的计量方法(IFRS vs. US GAAP);
• 定量掌握关联企业上下游交易对报表的调整;
• 重点理解使用Equity Method对于B/S & I/S以及ratio的影响。
71

Intercorporate Investments
Business Combinations
Tasks:
➢ Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for Business combinations.
➢ Distinguish between IFRS and US GAAP in the classification, measurement, and disclosure of Business combinations .
72

Business Combinations – 概述
=100%: 不产生MI
并购>50%或实 际控制
Acquisition Method
<100%: 产生MI
73

Business Combinations – 概述
Acquisition Method: (PP = FV子 = BV子时)
Balance Sheet
A母 +A子 –PP=A合 L母 + L子 = L合
E 母 + MI = E合 MI = (1 - %) * FV子
Income Statement
Sales母 + Sales子 = Sales合
Exp母 EBIT母
NI 母

• Exp子 + EBIT子
  = Exp合
  = EBIT合
  [注:MI= (1 - %)* NI子]

  • MI

• % NI 子 = NI 合
  74

  Business Combinations – 概述 问题一: 合并后的报表平吗?
  A母 +A子 –PP
  L母+L子 E 母 + MI
  75

  Business Combinations – 概述
  问题二: 题目给出以下四列，合并时选取哪两列数字? FV母 BV母 FV子 BV子
  76

  Business Combinations – 概述 问题三:
  购买股份时，用的不是现金，而是增发股票方式，怎么处理?
  Cash
  Capital – par Value
  Capital – Additional Paid-in Capital
  77

  Business Combinations – 概述 问题四:
  如果 FV子> BV子, 怎么处理?
  78

  Business Combinations – 概述 问题五:
  如果 PP > FV子, Goodwill怎么处理?
  79

  Business Combinations – 概述 Goodwill : 一般计算法则
  80

  Business Combinations – 概述 Goodwill:合并报表中的商誉计算
  1)GAAP Difference
  US GAAP: Full Goodwill
  Partial Goodwill Full Goodwill
  IFRS:
  81

  Business Combinations – 概述 Goodwill:

2. 计算方法
   被收购企业
   PP
   FV
   BV
   收购80%股权
   800
   400
   240
   收购100%股权
   1000
   500
   300
   Partial Goodwill = 800 – 400 = 400 Full Goodwill = 1000 – 500 = 500
   82

   Business Combinations – 概述 Goodwill:

3. 计算方法
   P. GW MIP = (1-%) * FV NIA F. GW MIF = (1-%) * FV 子
   83

   Business Combinations – 概述 Goodwill:

4. 减值
   •IFRS: Carrying Value Vs Recoverable Amount(Unit)
   •US: Step1 – Testing: Carrying Value Vs Fair Value(Unit)
   Step2 – Calculation: Carrying Value Vs Fair Value(GW)
   84

   Business Combinations – 概述 Goodwill:

5. 减值后的转回 2种准则下均不能转回
   5)商誉减值为0后的后续处理
   •IFRS: GW减为0后，继续减记其他资产 •US: GW减为0后，不再减记其他资产
   85

   Business Combinations
   Definition of Business Combinations
   ➢ Business combinations (controlling interest investments) involve the combination of two or more entities into a larger economic entity.
   • Under IFRS, there is no distinction among business
   combinations based on the resulting structure of the larger
   economic entity.
   • Under US GAAP, business combinations are categorized as:
   ✓ Merger (吸收合并)
   ✓ Acquisition (收购)
   ✓ Consolidation (新设合并)
   86

   Business Combinations in US GAAP
   Merger (吸收合并)
   ➢ The distinctive feature of a merger is that only one of the
   entities remains in existence. One hundred percent of the target is absorbed into the acquiring company. (Acquire 100% of the target)
   • Company A + Company B = Company A
   87

   Business Combinations in US GAAP
   Acquisition (收购)
   ➢ Each entity continues operations but is connected through a
   parent–subsidiary relationship. Each entity is an individual that maintains separate financial records, but the parent (the acquirer) provides consolidated financial statements in each reporting period.
   • Company A + Company B = (Company A + Company B)
   88

   Business Combinations in US GAAP
   Consolidation (新设合并)
   ➢ The distinctive feature of a consolidation is that a new legal
   entity is formed and none of the predecessor entities remain in existence. A new entity is created to take over the net assets of Company A and Company B. (Acquire 100% of the target)
   • Company A + Company B = Company C
   89

   Accounting Treatment for Business Combination
   Pooling-of-Interests Method (US GAAP, Prior to June 2001)
   ➢ Combining companies that met twelve strict criteria.
   Companies not meeting these criteria used the purchase
   method.
   ➢ The target’s assets and liabilities are stated at their book value
   in the consolidated financials statements.
   ➢ Operating results for prior periods are restated as though the
   two firms were always combined.
   ➢ Similar rules applied under IFRS, which used the term uniting
   of interests method. (IFRS, Prior to March 2004)
   ➢ Currently, neither IFRS nor US GAAP allows use of the pooling
   or uniting of interests method. 90

   Accounting Treatment for Business Combination
   Purchase Method (US GAAP & IFRS)
   ➢ The assets and liabilities acquired by the Parent should be
   stated at fair value in the consolidated financials statements. ➢ An increase in the value of depreciable assets resulted in
   additional depreciation expense. As a result, for the same level of revenue, the purchase method resulted in lower reported income than the pooling of interests method.
   ➢ Now, the acquisition method which replaces the purchase method is required in both US GAAP and IFRS.
   91

   Accounting Treatment for Business Combination
   Acquisition Method (US GAAP & IFRS)
   ➢ All of the assets, liabilities, revenues, and expenses of the
   subsidiary are combined with parent.
   ➢ Intercompany transactions are excluded.
   ➢ The acquisition method addresses three major accounting
   issues that often arise in business combinations.
   • The recognition and measurement of the assets and liabilities
   of the combined entity.
   • The initial recognition and subsequent accounting for goodwill.
   • The recognition and measurement of any non-controlling
   interest.
   92

   Example of Acquisition Method – B/S
   ➢ Suppose that on January 1st ,2016, Company A acquires 80% of the common stock of Company B by paying $8,000incashtotheshareholdersofCompanyB.Thepre-acquisitionbalancesheetofCompanyAandCompanyBareshownbelow:B/SItemsCurrentassetsOtherassetsTotalCurrentliabilitiesCommonstockRetainedearningsTotalCompanyA($) Pre-Acquisition
   48,000
   32,000
   80,000
   40,000
   28,000
   12,000
   80,000
   Company A ($)Post-Acquisition40,00032,000+800080,00040,00028,00012,00080,000CompanyB($)
   16,000
   8,000
   24,000
   14,000
   6,000
   4,000
   24,000
   93

   Example of Acquisition Method – B/S
   ➢ In an acquisition, the assets and liabilities are combined.
   ➢ Under the equity method, Company A will report its 80% interest in
   company B in a one-line investment account on the balance sheet.
   B/S Items
   Current assets
   Investment in B
   Other assets
   Total
   Current liabilities
   Common stock
   Minority Interest
   Retained earnings
   Total
   Acquisition Method ($)56,00040,00096,00054,00028,0002,00012,00096,000EquityMethod($)
   40,000
   8,000
   32,000
   80,000
   40,000
   28,000
   12,000
   80,000
   94

   Minority Interest
   Non-controlling interests:
   ➢ A minority interest (少数股东权益) is the portion of the subsidiary’s equity that is held by third parties.
   ➢ When Company A reports 100% of Company B’s assets and liabilities even though Company A only owns 80%. The remaining 20% of Company B is owned by minority investors and the difference is accounted for using a minority interest account.
   • Minority interest = 20% x (4000+6000) = 2000
   95

   Goodwill
   A more complicated example of combination B/S:
   ➢ Company A acquired 100% interest of Company B, the total consideration (收购对价) is $500M.
   • TIPS: 使用Acquisition method时必须要使用正确的时点数
   据。
   ✓ Acquirer: 使用收购完成时的报表数据。
   ✓ Target: 使用调整完成后的公允价值报表数据。
   96

      B/S Items
   

Company B (Historical)
Company B (Adjusted)
Company A (Post - Acquisition)
Adjustment for Acquisition Method
Acquisition Method
Cash
30
30
600-500=100
130
Inventory
50
50+30=80
150
Goodwill = 500 - (560-180) = 120
230
A/R
50
50
150
200
PP&E
250
250+50=300
400
700
Intangible asset
0
0+100=100
0
100
Investment
0
0
0+500=500
-500
0
Goodwill
0
0+120=120
0
120
Total asset
380
380+300=680
1300
1480
A/P
180
180
400
580
Capital
150
150
550
-150
550
R/E
50
50
350
-50
350
FV adjusted
0
0+300=300
0
-300
0
Total L + E
380
680
1300
1480
97

Goodwill
Recognition and Measurement of Goodwill:
➢ IFRS allows two options for recognizing goodwill.
• Full goodwill = Fair value of equity of whole subsidiary –
fair value of net identifiable net assets of the subsidiary
• Partial goodwill = Purchase price - % Owned x Fair value of
net identifiable assets of the subsidiary
➢ US GAAP allows full goodwill method only.

• Fair value of net identifiable net assets of the subsidiary= fair value of all identifiable tangible and intangible assets, liabilities, and contingent liabilities.
  98

  Example
  Company A paid $450 million for 75% of the stock of company B. Calculate the amount of goodwill Company A should report using the full goodwill method and the partial goodwill method.
  B/S items
  Book Value (million)
  Current assets
  80
  PP&E
  760
  Goodwill
  30
  Liabilities
  400
  Equity
  470
  The fair value of the PP&E was $120 million more than its recorded book value. The fair values of all other identifiable assets and liabilities were equal to their recorded book value.
  99

  Answer
  ➢ Full goodwill method
  • Fair value of the subsidiary = 450 / 0.75 = 600 million
  • Fair value of identifiable net assets
  ✓ =80+(760+120)–400=560million
  • Acquisition goodwill = 600 – 560 = 40 million
  ➢ Partial goodwill method
  • Purchase price = 450 million
  • Proportionate share of the fair value of identifiable net assets
  ✓ = 0.75 x 560 = 420 million
  • Acquisition goodwill = 450 – 420 = 30 million
  100

  Measurement of Minority Interest
  Measurement of minority interest:
  ➢ Goodwill is lower using the partial goodwill method. How is
  this reflected on liabilities and equity side of the balance sheet?
  ➢ Under full goodwill method, minority interest is based on the acquired company’s fair value.
  • 600 x 25% = 150 million
  ➢ Under partial goodwill method, minority interest is based on the fair value of the acquired company’s identifiable net assets. • 560 x 25% = 140 million
  ➢ The full goodwill method results in higher total assets, higher total equity and lower ROE than the partial goodwill method.
  101

  Impairment of Goodwill
  Although goodwill is not amortized, it must be tested for impairment at least annually.
  ➢ Under IFRS, if the carrying amount of the cash generating unit
  exceeds the recoverable amount, an impairment loss is
  recognized. (single step approach)
  ➢ Under US GAAP, goodwill impairment involves two steps.

1. Impairment exists if the carrying value of the reporting unit (including the goodwill) exceeds its fair value.

2. The loss is measured as the difference between the carrying value and implied fair value of the goodwill.
   102

   Example of Goodwill Impairment
   A reporting unit of a US corporation has a fair value of $1,300,000 and a carrying value of $1,400,000 that includes recorded goodwill of $300,000. The estimated fair value of the identifiable net assets of the reporting unit at the impairment test date is $1,200,000. (The recoverable amount of the cash-generating unit is determined to be €1,300,000.) Calculate the impairment loss.
   ➢ Under IFRS
   • Recoverable amount of unit < Carrying amount of unit
   • Impairment loss = 1.3 m – 1.4 m = €100,000
   103

   Example of Goodwill Impairment in US GAAP
   ➢ Under US GAAP
   • Step 1 – Determination of an Impairment Loss
   ✓ $1,300,000 (Fair value of unit) < $1,400,000 (Carrying value)
   • Step 2 – Measurement of the Impairment Loss
   ✓ Fair value of unit – fair value of net identifiable asset = $1,300,000 - $1,200,000
   = $100,000 (Implied goodwill)
   ✓ Impairment loss = Carrying value of GW – Implied GW = $300,000 - $100,000
   = $200,000
   104

   Bargain Purchase
   In rare case, acquisition purchase price is less than the fair value of net asset acquired.
   ➢ Both IFRS and US GAAP require that the difference between
   fair value of net assets and purchase price be recognized as gain in the income statement.
   105

   Acquisition Method – I/S
   Original income statement:
   I/S Items
   Company A ($)CompanyB($)
   Revenue
   60,000
   20,000
   Expense
   (40,000)
   (16,000)
   Net income
   20,000
   4,000
   Consolidated income statement: (80% acquisition)
   I/S Items
   Acquisition Method ($)EquityMethod($)
   Revenue
   80,000
   60,000
   Expense
   (56,000)
   (40,000)
   Operating income
   24,000
   20,000
   Equity income
   3,200
   Minority interest
   (800)
   Net income
   23,200
   23,200
   106

   Summary of Acquisition Method – I/S
   ➢ Some items might be adjusted due to the fair value adjustment:
   • COGS is adjusted to reflect the fair value of inventory of the target prior to acquisition.
   • Depreciation is adjusted to reflect the fair value of PP&E of the target prior to acquisition. ( the same method for Intangible Assets )
   107

   Summary of Acquisition Method – I/S
   ➢ Some items might be adjusted due to the fair value adjustment (Conts):
   • Minority interest is created by multiplying the subsidiary’s
   net income by the percentage of the subsidiary not owned. ✓ Minority interest is subtracted in arriving at
   consolidated net income. ➢ Goodwill is not amortized.
   108

      B/S Items
   

Company B (Historical)
Company B (Adjusted)
Company A (Post - Acquisition)
Adjustment for Acquisition Method
Acquisition Method
Cash
30
30
600-500=100
130
Inventory
50
50+30=80
150
230
A/R
50
50 150
200
PP&E
250
250+50=300
400
700
Intangible asset
0
0+100=100
0
100
Investment
0
0
0+500=500
-500
0
Goodwill
0
0+120=120
0
120
Total asset
380
380+300=680
1300
1480
A/P
180
180
400
580
Capital
150
150
550
-150
550
R/E
50
50
350
-50
350
FV adjusted
0
0+300=300
0
-300
0
Total L + E
380
680
1300
1480
109

Example of Acquisition Method – I/S
➢ Remaining useful lives of PP&E of target company are 10 years. • 调整公允价值后的固定资产会增加额外折旧:50/10 = 5
➢ Remaining useful lives of intangible assets are 10 years. • 调整公允价值后的无形资产会增加额外摊销:100/10 = 10
➢ Inventory increased fair value of 30.
B/S Items
Acquiror ($)Target($)
Fair Value Adjustment ($)AcquisitionMethod($)
Revenue
2,000
1,000
3,000
COGS
(1,000)
(6,00)
(30)
(1,630)
Dep. of PP&E
(40)
(30)
(5)
(75)
Amort. of I/A
0
0
(10)
(10)
SG&A
(300)
(200)
(500)
Taxation
(200)
(50)
(250)
Net income
460
120
(45)
535
110

Summary
➢ Importance: ☆☆☆ ➢ Content:
• Definition of Subsidiary (重点辨析和Associate的区别)
• Acquisition Method (B/S，I/S的相关处理)
• 了解因公允价值调整对于对于Acquisition method的影响
• Full goodwill and partial goodwill method (IFRS & US GAAP)
• Impairment of goodwill (IFRS & US GAAP)
• Minority interest (Full & Partial goodwill)
➢ Exam tips:
• 此部分为考试重点，需要重点关注。
111

Intercorporate Investments
Joint Ventures, SPE & VIE
Tasks:
➢ Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for Joint Ventures, SPE & VIE.
➢ Distinguish between IFRS and US GAAP in the classification, measurement, and disclosure of Joint Ventures, SPE & VIE.
112

Definition of Joint Ventures
Definition of Joint Venture
➢ Ventures undertaken and controlled by two or more parties.
➢ IFRS identify the following common characteristics of joint ventures:
• A contractual arrangement exists between two or more ventures.
• The contractual arrangement establishes joint control.
➢ Both IFRS and US GAAP require the equity method of accounting for joint ventures.
113

Definition of SPE
Definition of Special Purpose Entities
➢ Special purpose entities (SPEs) are enterprises that are created to accommodate specific needs of the sponsoring entity.
➢ An SPE can take the form of a corporation, partnership, joint venture, or trust, the typical motivation is to reduce risk and thereby lower the cost of financing.
➢ SPEs are often structured such that the sponsor company has control over its financing / operating activities while third parties have controlling interest in the SPE’s equity.
➢ According to IFRS 10, the sponsoring entity must consolidate if it controls the SPE.
114

Definition of VIE
Definition of Variable Interest Entity
➢ The FASB uses the term variable interest entity (VIE) to describe a special purpose entity that meets certain conditions.
• At-risk equity is insufficient to finance the entity’s activities
without additional financial support.
• Equity investors lack any one of the following:
✓ The ability to make decisions ✓ The obligation to absorb losses ✓ The right to receive returns
➢ If an SPE is considered a VIE, it must be consolidated by the primary beneficiary that absorbs the majority of the risk and rewards.
115

SPE & VIE
➢ The basis issue in regarding with VIE or SPE is to consider whether it should be consolidated by the Primary Beneficiary. • In most cases, the creator/sponsor of the entity retains a
significant beneficial interest in the SPE even though it may
own little or none of the SPE’s voting equity.
➢ Consolidation of VIE or SPE will significantly affect the financial statements and ratios.
116

Summary
➢ Importance: ☆ ➢ Content:
• Definition of Joint venture (能判断特征)
• Definition of SPE & VIE (知晓SPE & VIE的合并规定) ➢ Exam tips:
• 此部分知识点相对比较独立，只是补充了合并报表的一些特殊情况， 在考试中多出现定性判定和辨析题。
117

Intercorporate Investments
Analysis of Financial Results
Tasks:
➢ Analyze how different methods used to account for intercorporate investments affect financial statements and ratios.
118

Acquisition vs. Equity Method
There are four important effects on the balance sheet and income statement items that result from the choice of accounting method.
➢ All methods report the same net income.
➢ Under acquisition method, equity will be higher by the
amount of minority interest.
➢ Assets and liabilities are higher under the acquisition method.
➢ Revenues and expenses are higher under the acquisition
method.
119

Acquisition vs. Equity Method
Reported financial results from different accounting methods:
Ratios
Equity Method
Acquisition Method
Net profit margin
Higher - sales are lower and net income is the same
Lower
ROE
Higher – equity is lower and net income is the same
Lower
ROA
Higher – net income is the same and assets are lower
Lower
120

Additional Issues in Combinations
Additional issues in business combinations
➢ In-process R&D
•
IFRS and U.S. GAAP recognize IPR&D acquired in a business combination as a separate intangible asset and measure it at fair value.
In subsequent periods R&D is subject to amortization upon completion if successfully completed or impairment if no product results.
•
121

Additional Issues in Combinations
Additional issues in business combinations (Cont.)
➢ Restructuring costs
• IFRS and US GAAP do not recognize restructuring costs that are
associated with the business combination as part of the cost of the acquisition. Instead, they are recognized as an expense in the periods the restructuring costs are incurred.
122

Summary
➢ Importance:☆☆☆ ➢ Content:
• Acquisition vs. Equity Method (重点辨析I/S & B/S)
• Effects on ratios (了解两种方法下各种财务比率的异同)
• Additional issues (了解两种特殊情况)
✓ In-process R&D
✓ Restructuring costs ➢ Exam tips:
• 这部分主要考查两种合并报表方法下对于财务数据的影响， 出题形式多为定性方式。
123

Employee Compensation: Post-Employment and Share-Based
Post-retirement Plan
Tasks:
➢ Describe the types of post-employment benefit plans and implications for financial reports.
124

Overview of Post-retirement Plan
The typical post-retirement plans include:
➢ Defined-contribution pension plan (DC)
• The amount contributed by employers are defined but the
future value of plan is unknown. ➢ Defined-benefit pension plan (DB)
• Employer promises to pay a certain annual amount to employees after retirement.
➢ Other post-retirement benefits (OPB)
• Life insurance premiums, health insurance, etc…
125

DC Plan
(☆)
Plan Type
Employer
Employee
DC

1. People keeps all contributions current.

2. Only financial liability is making
   contributions to employee’s account.

3. The plan must offer sufficient investment
   vehicles.

4. Own the plan and can transport account to
   other employment situations.

5. Bear all risk/return consequences of
   investment.

6. Must make all investment decisions given available investment vehicles.
   126

   DB Plan
   Plan Type
   Employer
   Employee
   DB

7. Liability of employer

8. Determined by stated criteria usually related to years of service and salary.

9. Sponsor (employer) is responsible for
   managing the plan asset.

10. Receive periodic payments starting at
    retirement.

11. Subject to “early termination” risk if
    employee is terminated early.

12. Not bear risk/return consequences of
    investment.
    127

    DB Plan
    DB术语:
    Plan Asset/Pension Asset
    PBO (projected benefit obligation)/ Pension liability Contribution
    Investment Return/ Actual Return
    Current Service Cost
    Interest Expense
    Past Service Cost
    Actuarial G/L
    128

    Summary
    ➢ Importance: ☆ ➢ Content:
    • Post-retirement Plan (了解常见的养老金分类)
    ✓ DC Plan 雇员承担投资风险
    ✓ DB Plan 雇主承担投资风险
    ✓ Other post-retirement benefits 保险或者其他福利
    ➢ Exam tips:
    • 考试主要考查的是DB Plan的会计处理。
    129

Employee Compensation: Post-Employment and Share-Based
Accounting for DB Plan — B/S Presentation
Tasks:
➢ Explain and calculate measures of a defined benefit pension obligation and net pension liability.
130

Projected Benefit Obligation
Definition of projected benefit obligation (PBO)
➢ PBO is the actuarial present value of all future pension benefits earned to date, based on expected future salary increases.
➢ PBO measures the value of the obligation, assuming the firm is going concern and the employees will continue to work for the company until they retire.
➢ *PBO changes as a result of current service cost, interest cost, past service cost, changes in actuarial assumptions and benefits paid to employees.
131

Projected Benefit Obligation
The way how PBO is created
132

Measurement of PBO
Current service cost
➢ The present value of benefits earned by the employees during the current period. Service cost includes an estimate of compensation growth if the pension benefits are based on future compensation.
Interest cost
➢ Interest cost is the increase in the obligation due to the passage of time. Interest cost is equal to the pension obligation at the beginning of the period multiplied by the discount rate.
Benefits paid
➢ Benefits paid will reduce the PBO.
133

Measurement of PBO
Past (prior) service costs
➢ Past (prior) service costs are retroactive benefits (追溯的利益) awarded to employees when a plan is initiated or amended.
• Under IFRS, past service costs are expensed immediately.
• Under US GAAP, past service costs are amortized over the
average service life of employees.
134

Measurement of PBO
Changes in actuarial assumptions (精算假设)
➢ Gains and losses that result from changes in variables such as
mortality, employee turnover, retirement age, and the discount rate.
• An actuarial gain will decrease the benefit obligation.
• An actuarial loss will increase the Obligation.
135

Funded Status of DB Plan
Definition of funded status:
➢ The difference in the benefit obligation and the plan assets is referred to as the funded status of the plan.
• If the plan assets exceed the pension obligation, the plan is
said to be overfunded.
• If the pension obligation exceeds the plan assets, the plan
is underfunded.
➢ Funded status = Fair value of plan assets – PBO ➢ Balance sheet asset / liability = Funded status
136

Balance Sheet Presentation
137

Example of PBO Change
John was hired on January 1st , 2016 and is eligible to participate in the company’s DB pension plan. He is promised an annual payment of 2% of his final annual salary for each year of service. John’s starting annual salary is $50,000. Calculate the PBO at the end of 1st and 2nd year.
➢ The discount rate is 8%
➢ John’s salary will increase by 4% per year (compensation growth rate) ➢ John will work for 25 years
➢ John will live for 15 years after retirement and receive 15 annual
pension benefit payments.
138

Example of PBO Change
PBO at the end of 2016
Year
Years of Service
Projected Salary ($)YearinRetirementBenefitPayment($)
Present Value ($)
2016
1
50,000

PBO = 3,460.01
2017
2
52,000

折
2039
24
123,235.78

现
2040
25
128,165.21

21,940.55
2041

1
2,563.30

2,563.30
折现
2055

15
2,563.30
*PV of 15 year annuity of $2,563.30 at 8% = $21,940.55
*PBO = $21,940.55 discounted at 8% for 24 years. 139
…
…
…
…

Example of PBO Change
PBO at the end of 2017
Year
2016
2017
2040
2041
2055
Years of Service
1
2
25

Projected Salary ($)
50,000
52,000
123,235.78
128,165.21

Year in Retirement

1
15
Benefit Payment ($)

5,126.61
5,126.61
5,126.61
Present Value ($)
PBO = 7,473.62
2039
24

折 现
43,881.09
折现
*PV of 15 year annuity of $5,126.61 at 8% = $43,881.09 *PBO = $43,881.09 discounted at 8% for 23 years.
140
…
…
…
…

Example of PBO Change
During 2017, the PBO increased $4,013.61. The increase is a result of current service cost and interest cost as follows:
➢ 2016 PBO $3,460.01

• Current service cost $3,736.81
  (PV of 15 payments of $2,563.30 in 23 years)
• Interest cost $276.80 ($3,460.01 x 8%)
  ➢ 2017 PBO $7,473.62

• The current service cost is the present value of the benefits earned during 2017 and the interest cost is the increase in the PBO due to the passage of time.
  141

  Summary
  ➢ Importance:☆☆ ➢ Content:
  • The presentation of PBO on balance sheet ✓ 掌握影响期末PBO变动的因素
  • The presentation of plan assets on balance sheet ✓ 掌握影响期末养老金资产余额的因素
  ➢ Exam tips:
  • 考试主要考查的是DB Plan在资产负债表上的披露方式。 • 定性考查企业某一年PBO的期末余额。
  142

  Employee Compensation: Post-Employment and Share-Based
  Accounting for DB Plan — Periodic Pension Cost
  Tasks:
  ➢ Describe the components of a company’s defined benefit pension costs under IFRS and US GAAP.
  143

  Pension Accounting
  PA:
  ✓ + Contribution ✓ + Actual Return ✓ - Benefit Paid
  PBO:
  ✓ + Current Service Cost ✓ + Interest
  ✓ + Past Service Cost
  ✓ + Actuarial G/L
  ✓ - Benefit Paid
  Fund Status = Net Pension A/L = PA - PBO

0, Overfunded <0, Underfunded
144

Pension Accounting
Net Pension A/L = PA - PBO:

1. Contribution

2. Actual Return

3. Current Service Cost 4) Interest

4. Past Service Cost

5. Actuarial G/L
   145

   Pension Accounting
   Pension Expense: US GAAP

   1. Contribution 2) Actual Return 3) Current S.C. 4) Interest

6. Past S.C.

7. Actuarial G/L
   A. 用 Expected Return 代替 B. Rate自定义，目的是
   Smooth
   C. Expected和Actual的差，
   计入Item 6)
   = Beg PBO * r
   (r: discount rate)
   Amortize
   BS: 1) Contribution I/S: 2) Expected Return I/S: 3) Current S.C.
   I/S: 4) Interest
   OCI: 5) Past S.C.
   OCI: 6) Actuarial G/L
   Corridor

   1. 10% max (PA, PBO)

8. 超额部分在remaining life中摊 销
   146

   Pension Accounting
   Pension Expense: IFRS
   BS:

9. Contribution

10. 0
    (Actual Return – Int Income)+Int Income

11. Current S.C.

12. Net Int Exp = Int Exp- Int Income 5) Past S.C.

13. Actuarial G/L

14. Actual Return – Int Income
    1)Contribution 2) Actual Return 3) Current S.C. 4) Interest

15. Past S.C.

16. Actuarial G/L
    ???
    I/S: I/S: I/S: OCI: OCI:
    = (PA-PBO) * r
    No Amt
    No Amt
    147

    Periodic Pension Cost
    Definition of total periodic pension cost (TPPC)
    ➢ TPPC is the employer’s contributions adjusted for changes in funded status. The expense to the company is either paid via contributions or deferred via a worsening of the plan’s funded status.
    ➢ TPPC = Employer contribution – (Ending funded status – Beginning funded status)
    ➢ TPPC = Current service cost + Interest cost – Actual return on plan assets -/+ Actuarial G/L due to changes in assumptions
    affecting PBO + Prior service cost
    148

    Periodic Pension Cost
    Total periodic pension cost in IFRS & US GAAP
    ➢ The main difference between US GAAP and IFRS is the allocation of total periodic pension cost between the income statement (pension expense) and OCI.
    ➢ Under both US GAAP and IFRS
    • TPPC = Periodic pension cost in I/S + Periodic pension cost
    in OCI
    149

    Periodic Pension Cost in US GAAP
    ➢ Current service cost: is the increase in the PBO that is the result of the employees working one more period. Current service cost is immediately recognized in the income statement.
    ➢ Interest cost: is the increase in the PBO due to the passage of time. It is calculated by multiplying the PBO at the beginning of the period by the discount rate.
    ➢ Expected return on plan assets: The return on the plan assets has no effect on the PBO. However, the expected return on plan assets will reduces pension expense.
    150

    Periodic Pension Cost in US GAAP
    ➢ Actuarial gains and losses: There are two components within
    actuarial gains and losses.

1. The gain or loss due to decrease or increase in PBO occurring on
   account of changes in actuarial assumptions.

2. The difference between actual and expected return on plan
   assets.
   • Actuarial gains and losses are recognized in OCI.
   ✓ UnderIFRS,actuarialgainsandlossesarenotamortized. ✓ UnderUSGAAP,actuarialgainsandlossesareamortized
   using the corridor approach.
   151

   Corridor Approach in US GAAP
   Once the beginning balance of actuarial gains and losses exceed 10% of the greater of the beginning PBO or plan assets, amortization is required. The excess amount over the “corridor” is amortized as a component of periodic pension cost in I/S over the remaining service life of the employees.
   ➢ The amortization of an actuarial gain reduces periodic pension cost.
   ➢ The amortization of an actuarial loss increases periodic pension cost.
   152

   Example of Corridor Approach
   Assume that the beginning balance of the PBO is $5,000,000, the beginning balance of fair value of plan asset is $3,900,000, and the beginning balance of unrecognized actuarial losses is $600,000. The expected average remaining working lives of the employee is 15 years. ➢ The corridor is $500,000, which is 10% of the PBO (selected as the
   greater of the PBO or the fair value of plan assets).
   ➢ Because the balance of unrecognized actuarial losses exceeds the
   $500,000 corridor, amortization is required. ($600,000 > $500,000 ) ➢ The amount of the amortization is $6,666.67
   • [ ($600,000 - $500,000) / 15 years ] = $6,666.67
   153

   Periodic Pension Cost in US GAAP
   ➢ Past service costs: When a firm adopts or amends its pension plan, the PBO is immediately increased.
   • Under US GAAP, instead of expensing the cost immediately,
   it is reported as a part of other comprehensive income and amortized over the remaining service life of the affected employees.

• Under US GAAP, the amortization of actuarial gains and losses and the amortization of past service costs reduces the volatility of periodic pension cost in I/S. Thus, the amortization process results in periodic pension cost in I/S that is “smoothed”.
  154

  Periodic Pension Cost in IFRS
  ➢ Current service cost: is the increase in the PBO that is the
  result of the employees working one more period. Current service cost is immediately recognized in the income statement.
  ➢ Interest cost: is calculated by multiplying the net pension
  liability or net pension asset by the discount rate used in
  determining the present value of the pension liability.
  • Under IFRS, the net interest expense/income is defined as the discount rate multiplied by the beginning funded status.
  • If the plan is underfunded, an expense is reported.
  • If the plan is overfunded, interest income is reported.
  155

  Periodic Pension Cost in IFRS
  ➢ Expected return on assets: Under IFRS, the expected rate of return on plan assets is implicitly assumed to be the same as the discount rate used for computation of PBO and a net interest expense/income is reported in I/S.
  ➢ Actuarial gains and losses: Under IFRS, actuarial gains and losses are not amortized.
  ➢ Past service costs: Under IFRS, the past service costs are recognized in periodic pension cost in I/S immediately. (not amortized)
  156

  Remeasurement
  Remeasurement is an account in OCI under IFRS and includes: ➢ Actuarial gains and losses = Changes in a company’s pension
  obligation arising from changes in actuarial assumptions. ➢ Net return on plan asset = Actual return – (plan assets x
  interest rate)

• Remeasurement is recognized in OCI and not subsequently amortized to the income statement.
  157

  Presentation
  Presentation of pension expense differ between IFRS and US GAAP:
  ➢ US GAAP: all components of periodic pension costs are
  reported in I/S as a single line item.
  ➢ IFRS: components may be reported in I/S separately.
  ➢ TPPC should be disclosed in the notes of financial statements.
  158

  Difference on Pension Costs recognition under US GAAP and IFRS
  159

  US GAAP VS IFRS
  160

  Example of Periodic Pension Cost
  161
  The following information is provided about the DB pension plan of
  a company:
  ➢ Employer contributions ➢ Current service costs ➢ Past service costs
  ➢ Beginning PBO
  ➢ Ending PBO
  ➢ Increase in PBO due to changes in
  actuarial assumption
  ➢ Beginning plan assets
  ➢ Ending plan assets
  ➢ Actual return on plan assets
  ➢ Benefits paid
  ➢ Unamortized actuarial losses (US GAAP only) ➢ Expected rate of return on plan assets
  ➢ Discount rate used in estimating PBO
  $1,200 $1,850 $120 $38,750 $43,619
  $628
  $28,322 $30.682
  $1,795 $635
  $3,150 6% 7.5%

  Example of Periodic Pension Cost
  Calculate:
  A. Total periodic pension cost.
  B. Periodic pension cost reported in I/S under US GAAP (ignore
  amortization of past service cost)
  C. Periodic pension cost in reported in I/S under IFRS.
  D. Periodic pension cost reported in OCI under US GAAP
  E. Periodic pension cost reported in OCI under IFRS.
  162

  Answer for Question A
  A: Total periodic pension cost.
  Answer:
  TPPC = employer contribution – change in funded status
  = 1,200 – [ (-12,937) – (-10,428) ] = $3,709
  Alternatively,
  TPPC = current service cost + interest cost +past service cost + actuarial losses

• actual return
  = 1,850 + 2,906 + 120 + 628 – 1,795 = $3,709

• Interest cost = Discount rate x Beginning PBO = 7.5% x 38,750 = $2,906
  163

  Answer for Question B
  B: Periodic pension cost reported in I/S under US GAAP.
  Answer:
  Corridor approach:
  Beginning PBO > Beginning plan assets, we take 10% of beginning PBO as corridor = $3,875; Since unamortized actuarial losses ($3,150) do not exceed $3,875, no amortization is necessary.
  Periodic pension cost = Current service cost + Interest cost – Expected return on plan assets
  = 1,850 + 2,906 - 1,699 = $3,057

• Expected return = Expected rate of return x Beginning plan assets
  = 6% x 28,322 = $1,699
  164

  Answer for Question C
  C: Periodic pension cost in reported in I/S under IFRS.
  Answer:
  Periodic pension cost = Current service cost + Past service cost +
  Net interest cost
  = 1,850 + 120 + 782 = $2,752

• Net interest cost = Discount rate x Beginning funded status = 7.5% x (-10,428) = -$782
  165

  Answer for Question D & E
  D: Periodic pension cost reported in OCI under US GAAP Answer:
  Periodic pension cost in OCI = Total periodic pension cost –
  periodic pension cost in I/S = 3,709 – 3,057 = $652
  E: Periodic pension cost reported in OCI under IFRS Answer:
  Periodic pension cost in OCI = Total periodic pension cost –
  periodic pension cost in I/S = 3,709 – 2,752 = $957
  166

  Summary
  ➢ Importance:☆☆☆ ➢ Content:
  • Periodic pension cost in I/S under IFRS & US GAAP
  ✓ 辨析IFRS和US GAAP在披露养老金费用是的异同点 ✓ Pension expense的计算
  ➢ Exam tips:
  • 此部分是这个Reading的核心且为重要考点，应从定性和定量两个角
  度掌握此部分知识点。
  167

  Employee Compensation: Post-Employment and Share-Based
  Analysis of Pension Accounting
  Tasks:
  ➢ Explain and calculate the effect of a defined benefit plan’s assumptions on the defined benefit obligation and periodic pension cost.
  168

  Assumptions of Defined Benefit Obligation and Periodic Pension Cost
  The firm discloses three assumptions used in its pension calculations:
  ➢ Discount rate: the interest rate used to compute the PV of the
  benefit obligation and the current service cost component of pension expense.
  • Based on interest rates of high quality corporate fixed income
  investments with a maturity profile similar to the future
  obligation.
  • Affects the PBO as well as pension expense.
  169

  Assumptions of Defined Benefit Obligation and Periodic Pension Cost
  The firm discloses three assumptions used in its pension calculations (Cont.):
  ➢ Rate of compensation growth: affects both the PBO and pension
  expense.
  ➢ Expected return on plan assets: assumed long-term rate of
  return on the plan’s investments.
  ✓ The expected return is assumed only under US GAAP.
  ✓ Under IFRS, expected return is equal to the discount rate.
  170

  Effect of Changing Pension Assumption
  Increasing the discount rate:
  ➢ Reduce PV; PBO is lower; improve the funded status.
  ➢ Usually result in lower pension expense because of lower
  service cost.
  • The current service cost is a PV calculation.
  ➢ Usually reduce interest cost (PBO * discount rate) unless the
  plan is mature.
  • The beginning PBO is reduced when the discount rate
  increases. For a nonmature plan this decrease more than offsets the impact of the increased rate at which we compute the interest cost.
  171

  Effect of Changing Pension Assumption
  Decreasing the compensation growth rate:
  ➢ Reduce future pension payments; PBO is lower; improve the funded status.
  ➢ Reduce current service cost and lower interest cost; pension expense will decrease.
  Increasing the expected return on plan assets (under US GAAP):
  ➢ Reduce periodic pension cost reported in I/S.
  • But will leave the total periodic pension cost unchanged.
  ➢ Not affect the benefit obligation or the funded status of the plan.
  172

  Effect of Changing Pension Assumption
  Effect on Items
  Increase Discount Rate
  Decrease Rate of Compensation Growth
  Increase Expected Rate of Return
  Balance Sheet Liability
  Decrease
  Decrease
  No Effect
  Total Periodic Pension Cost
  Decrease
  Decrease
  No Effect
  Periodic Pension cost in I/S
  Decrease*
  Decrease
  Decrease**
  ➢ *For mature plans, a higher discount rate might increase interest costs. In rare cases, interest cost will increase by enough to offset the decrease in the current service cost, and periodic pension cost will increase.
  ➢ **Under U.S. GAAP only. Not applicable under IFRS.
  173

  Assumption of other post-employment benefits
  Accounting for other post-employment benefits:
  ➢ The assumptions are similar for other post-employment benefits expect the compensation growth rate is replaced by a healthcare inflation rate. This constant rate is known as the ultimate healthcare trend rate.
  ➢ Firms can reduce the post-employment benefit obligation and periodic expense by:
  • Decreasing the near term healthcare inflation rate.
  • Decreasing the ultimate healthcare trend rate.
  • Reducing the time needed to reach the ultimate healthcare trend
  rate.
  174

  Summary
  ➢ Importance:☆☆☆ ➢ Content:
  • Effect of Changing Pension Assumption
  ✓ 掌握三大假设对于报表和财务比率的影响
  ➢ Exam tips:
  • 此部分主要定性考查三大精算假设的改变对报表以及财务比率的影
  响，是养老金计划的核心考点，请考生务必掌握。
  175

  Employee Compensation: Post-Employment and Share-Based
  Adjustment of Pension Accounting
  Tasks:
  ➢ Explain and calculate how adjusting for items of pension and other post-employment benefits that are reported in the notes to the financial statements affects financial statements and ratios
  176

  Adjusting Items of Pension Benefits for Analytical Purposes
  Several aspects of the accounting for pensions and other post-employment benefits can affect comparative financial analysis using ratios based on financial statements.
  ➢ Gross vs. net pension assets/liabilities
  • The firm’s total assets and total liabilities are both less than if the firm reported the gross amounts.
  • Under both IFRS and U.S. GAAP standards, the amount disclosed in the balance sheet is a net amount.
  ➢ Differences in assumptions used
  • Differences in key assumptions can affect comparisons across
  companies.
  177

  Adjusting Items of Pension Benefits for Analytical Purposes
  ➢ Differences between IFRS and U.S. GAAP in recognizing total periodic pension cost
  • Periodic pension costs may not be comparable. IFRS and U.S. GAAP differ in their provisions about costs recognized in P&L versus in OCI.
  ➢ Reporting of periodic pension costs in P&L may not be comparable.
  • Under US GAAP, all of the components of pension costs in P&L are
  reported in operating expense on the income statement even though some of the components are of a financial nature. (interest expense and the expected return on assets)
  • Under IFRS, the components of periodic pension costs in P&L can be included in various line items.
  178

  Adjusting Items of Pension Benefits for Analytical Purposes
  ➢ Analysts can adjust GAAP-reported income by: (ignores any amortization)
  • Adding back the periodic pension cost in I/S and subtracting only service cost in determining operating income.
  • Interest cost should be added to the firm’s interest expense.
  • Actual return on plan assets should be added to non- operating income.
  179

  Example of Reclassifying Periodic Pension Cost
  Use the following information to reclassify the components of periodic pension cost between operating and nonoperating items:
  ➢ Operating profit = $145,000
  ➢ Interest expense = ($12,000)
  ➢ Other income = $2,000
  ➢ Income before tax = $ 135,000
  ➢ Other data:
  • Current service cost = $7,000
  • Interest cost = $5,000
  • Expected Return on assets = $8,000
  • Actual return on assets = $9,500
  180

  Example of Reclassifying Periodic Pension Cost
  Answer:
  ➢ Periodic pension cost (in P&L) of $4,000 ($7,000 current service cost + $5,000 interest cost - $8,000 expected return on assets) is added back to operating profit.
  ➢ Service cost of $7,000 is subtracted from operating profit.
  ➢ Interest cost of $5,000 is added to interest expense.
  ➢ The actual return on assets of $9,500isaddedtootherincome.I/SReported($)
  Adjustments ($)Adjusted($)
  Operating profit
  145,000

• 4,000 – 7,000
  142,000
  Interest expense
  (12,000)

• 5,000
  (17,000)
  Other income
  2,000

• 9,500
  11,500
  Income before tax
  135,000
  136,500
  181

  Analyst’s View on Cash Flow Adjustment
  Cash flow refers to pension including the amount of contribution
  and the amount of benefits paid.
  ➢ If the firm’s contributions exceed its total periodic pension cost, the
  difference can be viewed as a reduction in the overall pension
  obligation.
  ➢ if the total periodic pension cost exceeds the contributions, the
  difference can be viewed as a source of borrowing.
  ➢ If the difference between cash flow and total periodic pension cost is
  material, the analyst should consider reclassifying the difference from operating activities to financing activities in the cash flow statement.
  182

  Analyst’s View on Cash Flow Adjustment
  Analysis of cash flow
  ➢ Over-contribution: contribution > total periodic pension costs
  • CFO adjustment = CFO + (Contribution - TPPC)(1-t)
  • CFF adjustment = CFF - (Contribution - TPPC)(1-t)
  (Repayment)
  ➢ Under-contribution: contribution < total periodic pension
  expenses
  • CFO adjustment = CFO - (TPPC - Contribution)(1-t)
  • CFF adjustment = CFF + (TPPC - Contribution)(1-t)
  (Borrowing)
  183

  Example of Adjusting Cash Flow
  An analyst finds out a company made a $340 million contribution to the plan during the year. He collects the following additional information about the company:
  ➢ Beginning funded status = $2,530 million
  ➢ Ending funded status = $2,180 million
  ➢ Net income of the company = $812 million
  ➢ CFO = $948 million
  ➢ CFF =$112 million
  ➢ Tax rate = 40%
  Calculate the total periodic pension cost during the year.
  Calculate CFO and CFF after making appropriate adjustments.
  184

  Example of Adjusting Cash Flow
  Answer:
  ➢ Total periodic pension cost = contributions – (ending funded status - beginning funded status)
  = 340 – (2,180 – 2,530) = 340 – (-350) = $690 million
  ➢ The company’s contribution were $350 million less than TPPC
  • After tax shortfall = 350(1 - 0.4) = $210 million
  • Adjusted CFO = 948 - 210 = $738 million
  • Adjusted CFF = 112 + 210 = $322million
  185

  Summary
  ➢ Importance: ☆ ☆ ☆
  ➢ Content:
  • Adjusting Items of Pension Benefits for Analytical Purposes
  ✓ 掌握I/S的调整
  ✓ 重点掌握分析师如何调整养老金的现金流
  ➢ Exam tips:
  • 此部分多以定性判断以及定量计算为主，主要是站在分析
  师的角度分析各种和养老金相关的可能带来数据操纵的科
  目。
  186

  Employee Compensation: Post-Employment and Share-Based
  Share-based Compensation
  Tasks:
  ➢ Explain issues associated with accounting for share-based compensation.
  ➢ Explain how accounting for stock grants and stock options affects financial statements, and the importance of companies’ assumptions in valuing these grants and options.
  187

  Share-based Compensation
  Share-based compensation plans can take several forms , including stock options and share grants.
  ➢ They have the advantages of serving to motivate and retain
  employees as well as being a way to reward employees with
  no additional outlay of cash.
  ➢ Stock compensation plan takes many forms
  • Stock options
  • Stock grants
  • Stock appreciation rights
  • Phantom shares
  Equity settled (权益结算)
  Cash settled (现金结算)
  188

  Accounting for Share-based Compensation
  ➢ Stock options
  • Compensation expense is based on the fair value of the
  options on the grant date based on the number of options that are expected to vest.
  ✓ The vesting date is the first date the employee can
  actually exercise the options.
  ✓ The compensation expense is allocated in the income
  statement over the service period. (grand date to vesting date)
  189

  Accounting for Share-based Compensation
  ➢ Stock options (Cont.)
  ✓ Fair value of the stock option at the grant date is used
  to determine the compensation expense over the
  service period.
  ✓ Recognition of compensation expense will decrease
  net income and retained earnings; however, paid-in capital is increased by an identical amount. This results in no change to total equity.
  190

  Accounting for Share-based Compensation
  ➢ Stock options

  • Option pricing model can be used to determine the fair value of stock options. (eg: BSM,…)
    191

  Accounting for Share-based Compensation
  ➢ Stock grants
  • Compensation expense for stock granted to an employee is
  based on the fair value of the stock on the grant date.
  • The compensation expense is allocated over the employee’s
  service period. (grand date to vesting date)
  ➢ Types of stock grants
  • Transfer of stock without condition: Vesting immediately at
  grant date.
  • Restricted stock: Transferred stock cannot be sold until vesting
  date.
  • Performance stock: Contingent on meeting performance goals
  (eg: EPS, ROE, etc…).
  ✓ May result in manipulation
  192

  Accounting for Share-based Compensation
  ➢ Stock appreciation rights
  • The difference between a stock appreciation right and an
  option is the form of payment.
  • A stock appreciation award gives the employee the right to
  receive compensation based on the increase in the price of
  the firm’s stock over a predetermined amount.
  • The firm might pay the appreciation in cash, equity, or a
  combination of both.
  • Since no shares are actually issued, there is no dilution to
  existing shareholders.
  193

  Accounting for Share-based Compensation
  ➢ Phantom stock
  • Phantom stock is similar to stock appreciation rights
  except the payoff is based on the performance of
  hypothetical stock instead of the firm’s actual shares.
  • Phantom stock can be used in privately held firms and
  firms with highly illiquid stock.
  194

  Summary
  ➢ Importance: ☆
  ➢ Content:
  • Accounting for Share-based Compensation
  ✓ 掌握四种权益授予薪酬(奖金)的形式
  ✓ 其中重点是股票期权授予和直接授予股票这两种形式
  ➢ Exam tips:
  • 此部分多以定性判断为主，作为养老金福利的补充，考生要重点了
  解Stock Option和Stock Grants的账务处理。
  195

  Summary
  概念
  会计处理
  N * X% * $

5. 分析师调整
   DC
   基本
   概念
   DB
   养老金
   计算 方法

   1. PA: ABC 1) PA: ABC
   2. PBO:ABC IP 2) PBO:ABC IP
      记账 方法
   3. Pension Expense 3) Pension Expense
      TPPC= I/S+OCI
      US: 规律表
      IFRS: 规律表
   4. r / g / R 的影响 4) r / g / R 的影响
      Stock Option
      Pension Exp Cash Flow
      196

   Employee Compensation: Post-Employment and Share-Based
   Tasks:
   ➢ Exercises
   Post-retirement Plan Exercises
   197

   Exercises - 1
   198

   Exercises - 1
   199

   Exercises - 2
   200

   Exercises - 3
   201

   Exercises - 4
   202

Multinational Operations
Classification of Currencies in Multinational Financial Reporting
Tasks:
➢ Distinguish among presentation (reporting) currency, functional currency, and local currency.
➢ Describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses.
203

Influence of Foreign Currency Accounting
Foreign currency can affect a multinational firm’s financial statements in two ways:
➢ The multinational company may engage in business transactions
that are denominated in a foreign currency.
• Foreign currency transaction
➢ the multinational company may invest in subsidiaries that
maintain their books and records in a foreign currency.
• Foreign currency translation (考试主要针对考查这种情况)
204

Classification of Currencies
Currencies that are involved in multinational accounting
➢ The local currency
• The currency of the country in which the entity is located.
➢ The functional currency (之后章节会介绍详细的认定标准)
• The currency of the primary economic environment in which the entity
operates. It is usually the currency in which the entity generates and
expends cash.
• The functional currency can be the local currency or some other currency.
➢ The presentation (reporting) currency
• The currency in which the parent company prepares its financial
statements .
205

Foreign Currency Transactions
Foreign currency denominated transactions are measured in the presentation (reporting) currency at the spot rate on the transaction date.
➢ Foreign currency risk arises when the transaction date and the
payment date differ.
206

Foreign Currency Transactions
Treatment of foreign currency transactions:
➢ Transactions in foreign currencies are translated into the functional currency at the exchange rates at the date of transaction.
➢ Monetary assets and liabilities dominated in foreign currencies at the balance sheet date are re-valued at the exchange rate at that date.
➢ Differences arising on the transactions are recognized on the I/S.
207

Example of Foreign Currency Transactions
A U.S. firm that sells goods to an Italian company for €10,000 when the spot exchange rate is $1.60 per euro. Payment is due in 30 days. When payment is actually received, the euro has depreciated to $1. 50.
➢ On the transaction date, the U.S. firm recognizes a sale, and an account
receivable, in the amount of $16,000 (€10,000 x $1.60)
➢ On the payment date, the U.S. firm receives €10,000 and immediately
converts the euros to $15,000 (€10,000 x $1.50)
➢ As a result of the depreciating euro, the U.S. firm recognizes a $1,000
loss in the income statement.
➢ The Italian firm recognized no gain or loss since the purchase and
settlement transactions were both denominated in euros.
208

Example of Foreign Currency Transactions
S- Date before B/S date:
AR = € 10,000 S0 = $1.6/€ S1 = $1.5/€ S2 = $1.4/€
S0 S1 S2 T-day S-day BS-day
209

Example of Foreign Currency Transactions
S- Date after B/S date:
AR = € 10,000 S0 = $1.6/€ S1 = $1.5/€ S2 = $1.4/€
S0 S1 S2 T-day BS-day S-day
210

Foreign Currency Transactions
Analytical issues and disclosure analysis
➢ While transaction gains and losses are recognized in the income statement, the accounting standards do not provide any guidance to include them within operating or non-operating income.
➢ Neither standard requires disclosure of where such gains/losses would be recorded.
➢ The comparability of operating margins between entities would be diminished if the compared entities used different methods.
211

Summary
Impact due to changes in foreign currency exchange rate
Transactions
Types of Exposure
Foreign Currency
Appreciation
Depreciation
Export Sales
Asset (A/R)
Gain
Loss
Import Purchase
Liability (A/P)
Loss
Gain
212

Summary
➢ Importance: ☆
➢ Content:
• Accounting for foreign currency transactions
✓ 主要掌握在进行外贸交易时，由于应收款或者应付款科目在 记账日和结算日间由于外币汇率发生波动而带来利得或者损 失的记账方法。
➢ Exam tips:
• 此部分多以定性判断为主，重点是辨析Transaction和Translation的
区别，Foreign currency transaction不是考试重点，但需要了解。
213

Multinational Operations
Accounting for Multinational Operations — Introduction
Tasks:
➢ Compare the current rate method and the temporal method, evaluate how each affects the parent company’s balance sheet and income statement, and determine which method is appropriate in various scenarios.
214

Foreign Currency Translation
Introduction

1. Local Currency (LC)

2. Functional Currency (FC) 3) Presentation Currency(PC)
   母公司: PC C- Meth
   FC
   子公司: LC

3. Current FX Rate: 2) Average FX Date 3) Historical Rate
   B/S Date
   T- Meth
   215

   Foreign Currency Translation
   Overview
   ➢ Translation of foreign currency financial statements refers to the method used to translate the entity’s financial statements to Presentation Currency (reporting currency).
   ➢ Two methods are usually adopted in the translation under different scenarios:
   • Current rate method
   • Temporal method
   216

   Identification of Functional Currency
   According to the IASB, management should consider the following factors in deciding on the functional currency:
   ➢ The currency that influences sales prices for goods and services.
   ➢ Currency of the country whose competitive forces and
   regulations mainly determine the sale price of goods and
   services.
   ➢ The currency that influences labor, material, and other costs.
   ➢ The currency from which funds are generated.
   ➢ The currency in which receipts from operating activities are
   usually retained.
   ➢ The FASB provides similar guidance.
   217

   Current Rate Method & Temporal Method
   Determine the appropriate translation method:
   ➢ If the functional currency and the parent’s presentation currency differ, the current rate method is used to translate the
   foreign currency financial statements.
   • Translation usually involves self-contained, independent
   subsidiaries whose operating, investing, and financing activities are decentralized from the parent.
   ➢ If the functional currency is the same as the parent’s presentation currency, the temporal method is used to
   remeasure the foreign currency financial statements.
   • Remeasurement usually occurs when a subsidiary is well integrated
   with the parent.
   218

   Current Rate Method & Temporal Method
   Determine the appropriate translation method:
   ➢ In the case where the local currency the functional currency, and the presentation currency all differ, both the temporal method and the current rate method are used.
   219

   Current Rate Method & Temporal Method
   Determine the appropriate translation method (Cont.):
   ➢ Eg: Consider a U.S. firm that owns a German subsidiary whose functional currency is the euro. The German subsidiary is also denominating a few transactions in Swiss francs.
   • In this case, the temporal method is used to remeasure from the local currency (Swiss francs) into the functional currency (euros).
   • Then, the current rate method is used to translate from the functional currency (euros) to the presentation currency (U.S. dollar).
   220

   Current Rate Method & Temporal Method
   Determine the appropriate translation method:
   ➢ If a subsidiary is operating in a hyperinflationary environment, the functional currency is considered to be the parent’s presentation currency, and the temporal method is used under U.S. GAAP.
   ➢ Under IFRS, the subsidiary’s financial statements are restated for inflation and then translated using the current exchange rate .
   221

   Current Rate Method & Temporal Method
   Three Methods for Remeasurement or Translation:
   222

   Current Rate Method & Temporal Method
   We need to define a few exchange rates which will be used in applying the current rate and the temporal method.
   ➢ The current rate is the exchange rate on the balance sheet
   date.
   ➢ The average rate is the average exchange rate over the
   reporting period.
   ➢ The historical rate is the actual rate that was in effect when
   the original transaction occurred.
   223

   Current Rate Method
   Current Method
   Liab:
   Cur
   Cap: His
   Asset:
   Cur
   Equity:
   RET-1: His
   RE: NI: Div:
   CTA (倒轧)
   Avg His
   224

   Temporal Method
   Temporal Method
   Monetary Items: - Cash

• AR

• AP

• ST debt - LT debt
  Monetary Liab: Non-mon Liab:
  Cur His
  Monetary Asset: Non-mon Asset:
  Cur His
  Cap: His RET-1: His
  COGS/ Depr/ Amt:
  His
  Equity:
  RE:
  NI: I/S Div:
  Others: Avg Remeasurement G/L (倒轧)
  His
  225

  Current Rate Method
  Applying the Current Rate Method
  ➢ All income statement accounts are translated at the average rate.
  ➢ All balance sheet accounts are translated at the current rate except for common stock, which is translated at the historical (actual) rate that applied when the stock was issued.
  ➢ Dividends are translated at the rate that applied when they were declared.
  ➢ Translation gain or loss is reported in shareholders’ equity as a part of the cumulative translation adjustment (CTA).
  226

  Temporal Method
  Applying the Temporal Method
  ➢ Monetary assets and liabilities are remeasured using the
  current exchange rate.
  • Monetary assets and liabilities are fixed in the amount of currency to
  be received or paid and include: cash, receivables, payables, and short- term and long-term debt.
  ➢ All other assets and liabilities are considered nonmonetary and
  are remeasured at the historical (actual) rate.
  • The most common nonmonetary assets include inventory, fixed
  assets, and intangible assets. An example of a nonmonetary liability is unearned revenue.
  227

  Temporal Method
  Applying the Temporal Method
  ➢ Common stock and dividends paid are remeasured at the historical (actual) rate.
  ➢ Expenses related to nonmonetary assets such as COGS, depreciation expense, and amortization expense are remeasured based on the historical rates prevailing at the time of purchase.
  ➢ Revenues and all other expenses are translated at the average rate. ➢ Remeasurement gain or loss is recognized in the income statement. • This results in more volatile net income as compared to the
  current rate method.
  228

  Comparison of Two Methods – B/S
  B/S Items
  FX Rate under Temporal Method
  FX Rate under Current Rate Method
  Monetary Assets / Liabilities
  Current rate
  Current rate
  Non – Monetary Assets / Liabilities
  Historical rate
  Current rate
  Common stock
  Historical rate
  Historical rate
  Retain Earning
  Balancing (勾稽后得到)
  Balancing (勾稽后得到)
  Equity (as a whole)
  Mixed (Because the change in retained earnings is mixed)
  Current rate
  * Liability is usually regarded as monetary except for unearned revenue.
  229

  Comparison of Two Methods – I/S
  I/S Items
  FX Rate under Temporal Method
  FX Rate under Current Rate Method
  Revenue
  Average rate
  Average rate
  SG&A
  Average rate
  Average rate
  COGS
  Historical rate
  Average rate
  Depreciation
  Historical rate
  Average rate
  Net income
  Mixed rate
  Average rate
  Translation G/L
  Recognized on I/S (Affects retained earnings, no CTA)
  Recognized in equity (B/S, not through I/S) resulting in CTA
  230

  Inventory & COGS Under the Temporal Method
  Under Temporal Method, the inventories are re-measured at historical FX rate. The ending inventories are re-measured at the rate that existed when the inventories assumed to still be
  on hand at the B/S date was acquired.
  ➢ Under FIFO, the ending inventories are re-measured at relatively
  recent rate.
  ➢ Under LIFO, the ending inventories are re-measured at relatively
  older rate.
  ➢ The FX rate used in re-measuring the COGS will differ depending on
  the cost flow assumption, FIFO, LIFO and weighted average.
  231

  Inventory & COGS Under the Temporal Method
  关于存货的进一步解释:
  Inventory COGS
  FIFO:留下 最新 – Recent FX Rate LIFO: 留下最旧 – Old FX Rate
  FIFO: 结转最旧 – Old FX Rate LIFO: 结转最新 – Recent FX Rate
  232

  Comparison of Two Methods – FX Risk Exposure
  FX Exposure:
  折算方法
  轧差科目
  科目位置
  Exposure
  头寸(一般情况)
  外币升值
  外币贬值
  C-Meth
  CTA
  Equity
  Net Asset

0
Gain
Loss
T-Meth
Remt G/L
I/S
Net Mon Asset
<0
Loss
Gain
233

Summary
➢ Importance: ☆ ☆ ☆
➢ Content:
• Current Rate Method & Temporal Method
✓ 主要掌握两种方法分别是如何在利润表以及资产负债表中记 录汇兑损益。
➢ Exam tips:
• 这部分是考试的重中之重，要求会判断两种方法适用的
前提条件。
234

Multinational Operations
Accounting for Multinational Operations — Calculation
Tasks:
➢ Calculate the translation effects and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s presentation currency.
235

Calculating the Translation/Remeasurement Gain or Loss
Current Rate Method
➢ Company A is a U.S. company with a subsidiary, Company B, located in the country of M. Company B was acquired by Company A in 2014. Company A reports its financial results in U.S. dollars. The currency of M is the local currency (LC).
➢ Company B 2015 Income Statement
Revenue
5,000 (LC)
COGS
(3,300)
Gross margin
1,700
SG&A
(400)
Depreciation expense
(600)
Net income
700 (LC)
236

Company B December 31, 2014 and 2015 Balance Sheet
B/S Items
Cash
Account receivable
Inventory
Current assets
Fixed assets
Accumulated depreciation
Net fixed assets
Total assets
Accounts payable
Current debt
Long-term debt
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities and equity
2014 (LC)
100
500
1,000
1,600
800
(100)
700
2,300
400
100
1,300
1,800
400
100
500
2,300
2015 (LC)
100
650
1,200
1,950
1,600
(700)
900
2,850
500
400
800
1,200
2,850
200
950 1,650
Retained earnings on December 31 , 2014, were $50
237

Calculating the Translation/Remeasurement Gain or Loss
The following exchange rates between the
U.5. dollar and the LC were observed:
➢ December 31 , 2014: $0.50 = 1.00 LC
➢ December 31 , 2015: $0.4545 = 1.00 LC
➢ Average for 2015: $0.4762 = 1.00 LC
➢ Historical rate for equity: $0.50 = 1.00 LC
➢ Historical rate for fixed assets: $0.4881 = 1.00 LC
➢ Historical rate for accumulated depreciation = $0.4896 = 1.00 LC ➢ Historical rate for COGS = $0.4834 = 1.00 LC
➢ Historical rate for depreciation = $0.4878 = 1.00 LC
➢ Historical rate for ending inventory = Average rate during the year
238

Calculating the Translation/Remeasurement Gain or Loss
The majority of company’s operational, financial, and investment decisions are made locally in M, use the appropriate method to translate company B’s 2015 balance sheet and income statement into U.S. dollars.
Answer:
Company B is relatively self-contained, which likely means the LC is the functional currency, the current rate method is used to translate Company B’s financial statements from the functional currency to the parent’s
presentation currency.
239

Calculating the Translation/Remeasurement Gain or Loss
Company B’s 2015 Income Statement Under the Current Rate Method
I/S Items
2015 (LC)
Rate
2015 ($)
Revenue
5,000
0.4762 $/LC
2,381
COGS
(3,300)
0.4762 $/LC
(1,571.5)
Gross margin
1,700
809.5
SG&A
(400)
0.4762 $/LC
(190.5)
Depreciation expense
(600)
0.4762 $/LC
(285.7)
Net income
700
333.3
240

Company B’s 2015 Balance Sheet Under the Current Rate Method
B/S Items
2015 (LC)
Rate
2015 ($)
Cash
100
0.4545 $/LC
45.5
Account receivable
650
0.4545 $/LC
295.4
Inventory
1,200
0.4545 $/LC
545.4
Current assets
1,950
886.3
Fixed assets
1,600
0.4545 $/LC
727.2
Accumulated depreciation
(700)
0.4545 $/LC
(318.2)
Net fixed assets
900
409
Total assets
2,850
1,295.3
Accounts payable
500
0.4545 $/LC
227.2
Current debt
200
0.4545 $/LC
90.9
Long-term debt
950
0.4545 $/LC
431.8
Total liabilities
1,650
749.9
Common stock
400
0.5 $/LC
200
Retained earnings
800
383.3 (A)
CTA
0
(37.9) (B)
Total equity
1,200
545.4
Total liabilities and equity
2,850
1,295.3
241

Calculating the Translation/Remeasurement Gain or Loss
Company B’s 2015 Balance Sheet Under the Current Rate Method
➢ A: Beginning (2015) retained earnings were $50, so ending (2015) retained earnings are $50 + $333.3 = $383.3
➢ B: The CTA is a plug figure that makes the accounting equation balance
• CTA = Assets – Liabilities – Common stock – Retained earnings
= $1,295.3 – $749.9 – $200 – $383.3 = – $37.9
242

Calculating the Translation/Remeasurement Gain or Loss
The Temporal Method
➢ Suppose instead that the majority of Company B’s operational, financial, and investment decisions are made by the parent company A. Use the temporal method to translate Company B’s 2015 balance sheet and income statement into U.S. dollars.
➢ Under the temporal method, we’ll start with the balance sheet. • Next slides
243

Company B’s 2015 Balance Sheet Under the Temporal Method
B/S Items
2015 (LC)
Rate
2015 ($)
Cash
100
0.4545 $/LC
45.5
Account receivable
650
0.4545 $/LC
295.4
Inventory
1,200
0.4762 $/LC
571.4
Current assets
1,950
912.3
Fixed assets
1,600
0.4881 $/LC
781
Accumulated depreciation
(700)
0.4896 $/LC
(342.7)
Net fixed assets
900
438.3
Total assets
2,850
1,350.6
Accounts payable
500
0.4545 $/LC
227.2
Current debt
200
0.4545 $/LC
90.9
Long-term debt
950
0.4545 $/LC
431.8
Total liabilities
1,650
749.9
Common stock
400
0.5 $/LC
200
Retained earnings
800
400.7 (A)
Total equity
1,200
600.7
Total liabilities and equity
2,850
1,350.6
244

Calculating the Translation/Remeasurement Gain or Loss
Company B’s 2015 Balance Sheet Under the Temporal Method
➢ A: Retained earnings is a plug figure that makes the accounting equation balance:
• Retained earnings = Assets – Liabilities – Common stock
= $1,350.6 - $749.9 - $200 = $400.7 ➢ Then we see the income statement
245

Calculating the Translation/Remeasurement Gain or Loss
Company B’s 2015 Income Statement Under the Temporal Method
I/S Items
2015 (LC)
Rate
2015 ($)
Revenue
5,000
0.4762 $/LC
2,381
COGS
(3,300)
0.4834 $/LC
(1,595.3)
Gross margin
1,700
785.7
SG&A
(400)
0.4762 $/LC
(190.5)
Depreciation expense
(600)
0.4878 $/LC
(292.7)
Remeasurement G/L
48.2 (B)
Net income
700
350.7 (A)
246

Calculating the Translation/Remeasurement Gain or Loss
Company B’s 2015 Balance Sheet Under the Temporal Method
➢ A: Net income is derived from the beginning and ending balances of retained earnings and dividend paid:
• Beginning retained earnings + Net income – Dividend paid =
Ending retained earnings
• Net income = $400.7 - $50 = $350.7
➢ B: The remeasurement G/L is a plug that is equal to the difference in net income and income before remeasurement G/L:
• Remeasurement G/L = Net income – Income before
remeasurement G/L = $48.2
247

Current Rate Method vs. Temporal Method
Current Rate Method vs. Temporal Method
B/S & I/S Items
Current Rate Method ($)TemporalMethod($)
Translation G/L
-$37.9
(on the balance sheet)
$48.2
(on the income statement)
Net income
$333.3
$350.7
Total assets
$1,295.3
$1,350.6
248

Current Rate Method vs. Temporal Method
We can make the following observations:
➢ The translation gain/loss is different between the two
methods; it’s not even the same sign.
• The current rate method results in a translation loss, while the temporal method results in a translation gain. This is NOT an unusual occurrence.
• Under the current rate method, Company B’s net assets (assets > liabilities) are exposed to the depreciating local currency.
• Under the temporal method, Company B’s net monetary liabilities (monetary liabilities > monetary assets) are exposed. Holding net monetary liabilities in a depreciating environment results in a gain.
249

Current Rate Method vs. Temporal Method
➢ Net income is different between the two methods.
• This is because of the different exchange rates used to
translate COGS and depreciation expense.
• In addition, the gain/loss recognized under the two methods
are reported in different financial statements.
➢ Total assets are different between the two methods.
• This is because inventory and net fixed assets are different. Inventory and fixed assets are translated at the current rate under the current rate method but translated at historical rate under temporal method.
250

Summary
➢ Importance: ☆ ☆ ☆
➢ Content:
• Current Rate Method & Temporal Method
✓ 计算汇兑损益
✓ 定性分析两种方法下导致会计科目发生变化的原因。
➢ Exam tips:
• 这部分是考试的重中之重，要求掌握到熟练计算的程度。
251

Multinational Operations
Analysis for Multinational Company
Tasks:
➢ Analyze how the current rate method and the temporal method affect financial statements and ratios.
➢ Analyze how currency fluctuations potentially affect financial results, given a company’s countries of operation.
252

Financial Ratios under Current Rate & Temporal Method
Overview
C - Meth
Pure Ratio: 不受影响
Mixed Ratio: Case by case 分析
T - Meth: Case by case 分析
253

Financial Ratios under Current Rate & Temporal Method
➢ Pure balance sheet and pure income statement ratios.
• Pure statements means that all of the components of the
ratio are from the balance sheet, or all of the components
are from the income statement.
• Pure income statements and pure balance sheet ratios are
unaffected by the application of the current rate method. ✓ Both the numerator and denominator are from the balance
sheet and are translated at the current rate.
✓ Both the numerator and denominator are from the income
statement and are translated at the average rate.
254

Financial Ratios under Current Rate & Temporal Method
➢ Example of pure financial statement ratios.
B/S Items
2014 (LC)
2014 ($)(currentratemethod)Currentratio2.792.79Quickratio1.071.07LTDtototalcapital0.440.44I/SItems2014(LC)2014($) (current rate method)
Gross profit margin
34%
34%
Net profit margin
14%
14%
255

Financial Ratios under Current Rate & Temporal Method
➢ Mixed balance sheet & income statement ratios.
• A mixed ratio combines inputs from both the income
statement and balance sheet.
• The current rate method results in small changes in mixed
ratios because the numerator and the denominator are almost
always translated at different exchange rates.
• If we are using end-period balance sheet figures, there are
conclusions as following:
✓ The analysis that follows does not necessarily apply for mixed ratios calculated using beginning or average balance sheet figures.
256

Financial Ratios under Current Rate & Temporal Method
➢ Example of mixed financial statement ratios. (Depreciating LC)
Ratios
2015 (LC)
2015 ($) (current rate method)
ROA
24.6%
25.7%
ROE
58.3%
61.1%
Total asset turnover
1.75
1.84
Inventory turnover
2.75
2.88
Accounts receivable turnover
7.69
8.06
* Ratios are calculated using end-of-period balance sheet numbers.
➢ The translated ratio is larger than the original ratio. This will always be
the case when the foreign currency is depreciating because the average rate (分子) is greater than the ending rate (分母).
257

Summary of Original & Current Rate Method Ratios
➢ Pure balance sheet and pure income statement ratios will be the same.
➢ If the foreign currency is depreciating, translated mixed ratios (with an income statement item in the numerator and an end- of-period balance sheet item in the denominator) will be larger than the original ratio.
➢ If the foreign currency is appreciating, translated mixed ratios (with an income statement item in the numerator and an end- of-period balance sheet item in the denominator) will be smaller than the original ratio.
258

Current Rate V.S. Temporal Method Ratios
The basic procedure of analyzing the effect on the financial ratios of the choice of current rate and temporal method. (still base on end-of-period balance sheet figures)
➢ Determine whether the foreign currency is appreciating or depreciating.
➢ Determine which rate (historical rate, average rate, or current rate) is
used to convert the numerator under both methods.
➢ Determine which rate (historical rate, average rate, or current rate) is
used to convert the denominator under both methods.
➢ Determine whether the ratio will increase, decrease, or stay the same
based on the direction of change in the numerator and the denominator.
259

Current Rate V.S. Temporal Method Ratios
Example: Try to analyze the fixed asset turnover ratio, assumes the
foreign currency is depreciating.
Answer:
➢ The numerator (revenue) is converted at the same rate (the average rate) under both methods.
➢ The denominator (fixed assets) is converted at the historical rate under the temporal method and the current rate under the current rate method. If the foreign currency is depreciating, the historical rate will be higher than the current rate, which means fixed assets will be higher under the temporal method.
➢ Since fixed assets are higher, turnover will be lower under the temporal method. (higher denominator)
260

Tax Implications of Multinational Operations
Earnings of multinational companies are subject to multiple
tax jurisdictions; hence, the statutory tax rate often differs
from the effective tax rate.
➢ Changes in effective tax rate on account of foreign operations
can be due to:
• Changes in the mix of profits from different countries (with
varying tax rates).
• Changes in tax rates.
261

Revenue Growth Issue and Foreign Exchange Risks
Revenue growth can occur due to price or volume changes and due to changes in exchange rates.
➢ Analysts separate the two because the growth in revenues due
to price or volume changes are more sustainable.
Foreign exchange risks include the impact of changes in currency values on assets and liabilities of a business, as well as on future sales.
➢ Disclosures may enable an analyst to evaluate the impact of
changes in currency values on company’s business.
262

Summary
➢ Importance: ☆ ☆ ☆
➢ Content:
• 主要掌握不同方法下汇率转换导致的财务比例分析
✓ Current Rate Method V.S. Original
✓ Current Rate Method V.S. Temporal Method • 辨析有效税率和法定税率
➢ Exam tips:
• 这部分同样是考试重点考查的内容，知识比较繁杂，需要反复理
解和操练来加以巩固。
263

Multinational Operations
Analysis for Multinational Company — Hyper-inflationary Economy
Tasks:
➢ Analyze how alternative translation methods for subsidiaries operating in hyper- inflationary economies affect financial statements and ratios.
264

Translation Method in Hyperinflationary Economies
Definition of hyperinflationary environment
➢ According to the FASB, a hyperinflationary environment is one where cumulative inflation exceeds 100% over a 3- year period.
• Assuming compounding, an annual inflation rate of
more than 26% over three years (1.263 - 1 is
approximately equal to 100%).
• The temporal method is used to remeasure the
financial statements.
265

Translation Method in Hyperinflationary Economies
Definition of hyperinflationary environment
➢ The IASB does not specifically define hyperinflation.
➢ Under IFRS. The foreign currency financial statements are restated
for inflation and then translated using the current exchange rate.
• Nonmonetary assets and nonmonetary liabilities are restated for
inflation using a price index.
• It is not necessary to restate monetary assets and monetary
liabilities.
• The components of shareholders’ equity (other than retained
earnings) are restated by applying the change in the price index.
• The income statement items are restated by multiplying by the change in the price index from the date the transactions occur.
• The net purchasing power gain or loss is recognized in the income statement based on the net monetary asset or liability exposure.
266

Translation Method in Hyperinflationary Economies
恶性通胀

1. 定义: 3年累计超100%
   US GAAP:不调通胀(不作为)
   2) 处理方法:
   一律用 Temporal Method 折算报表
   IFRS:调通胀(人为调整)
   之后再用 current exchange rate 折算报表
   267

   Translation Method in Hyperinflationary Economies
   恶性通胀

2. 具体调整方法
   1 / 1: Price Beg 12 / 31: Price End
   1 / 1~12/31:Price
   3.1) Monetary Items: 不调整 3.2)Non-MonItems: 调整 3.3) REt-1: 不调整
   3.4) I/S: 调整
   PI: = Price PI’: = Price End
   / Price
   / Price Avg
   用于B/S科目调整 用于IS/科目调整
   End
   Beg
   Avg
   Net Monetary Asset : 会导致 NPP 3.5) 报表不平，倒轧:Net Purchasing Power G/Loss
   (NPP G/L) Net Monetary Liab: 会导致 NPP Gain
   268

   Example of Adjusting Financial Statements for Inflation
   In LC
   Cash
   Inventory
   Total assets
   Accounts payable
   Common stock
   Retained earnings
   Liabilities and equity
   Revenue
   Expenses
   CPI(2N0e1t4in/1c2o/m31e)=100
   5,000
   25,000
   30,000
   20,000
   10,000
   0
   30,000
   2015
   8,000
   25,000
   33,000
   20,000
   10,000
   3,000
   33,000
   15,000
   (12,000)
   3,000
   CPI (2015/12/31) = 150 Average CPI for 2015 = 125
   2014
   269

   Example of Adjusting Financial Statements for Inflation
   In LC
   Cash
   Inventory
   Total assets
   Accounts payable
   Common stock
   Retained earnings
   Liabilities and equity
   Revenue
   Expenses
   Net purchasing power gain / loss
   Net income
   2015
   8,000
   25,000
   33,000
   20,000
   10,000
   3,000
   33,000
   15,000
   (12,000)
   3,000
   Adjustment Factor
   150 / 100
   150 / 100
   150 / 125
   150 / 125
   Inflation Adjusted
   8,000
   37,500
   45,500
   20,000
   15,000
   10,500
   45,500
   18,000
   (14,400)
   6,900 (A)
   10,500
   270

   Example of Adjusting Financial Statements for Inflation
   Calculation of net purchasing power gain / loss
   ➢ A: Cash = 8000 = 5000 (受一整年的通胀影响) + 3000 (年中 受通胀影响，以平均值测算)
   • Monetary asset 受通胀影响会导致loss
   • Loss = [-5,000 x (150-100) / 100] + [-3,000 x (150-125)
   / 125]
   • Monetary liability受通胀影响会导致Gain
   • Gain = [20,000 x (150-100) / 100]
   • Net purchasing power gain / loss = Gain + Loss = 6,900
   271

   Summary
   ➢ Importance: ☆ ☆ ☆
   ➢ Content:
   • 计算恶性通货膨胀下导致的通胀损益
   ✓ Net purchasing power gain / loss ✓ 注意IFRS和US GAAP的对比
   ➢ Exam tips:
   • 这部分同样是重点考查的内容，需要定性、定量掌握IFRS和US
   GAAP对恶性通胀环境下外币财务报表折算的方法。
   272

   Summary
   Transaction
   S- Date before B/S date S- Date after B/S date
   Gain or Loss 如何判断
   跨国经营 (报表折算)
   折算方法的选择
   C - Method T - Method
   规律图 规律图
   Translation
   具体折算过程 C - Method T - Method
   FX Exposure Impact on Ratio 恶性通胀
   273

Multinational Operations
Multinational Operations Exercises
Tasks:
➢ Exercises
274

Exercises - 1
275

Exercises - 2
276

Exercises - 2
277

Exercises - 2
278

Exercises - 3
279

Exercises - 4
280

Exercises - 5
281

Exercises - 5
282

Evaluating Quality of Financial Reports
Evaluate the Reporting Quality
Tasks:
➢ Demonstrate the use of a conceptual framework for assessing the quality of a company’s financial reports.
283

Quality of financial reports
Quality of financial reports
➢ The quality of financial reports can be viewed along two highly related dimensions:
• Earnings quality
• Reporting quality (decision-useful)
➢ Reporting quality is an assessment of the information disclosed in the reports.
➢ High-quality earnings refers to a high level of earnings as well as sustainability of earnings. Good economic performance and sustainable earnings are considered higher quality.
284

Potential problems that affect the quality of financial reports
Potential problems
➢ Measurement and timing issues (Aggressive/conservative revenue recognition)
➢ Classification issues (operating/Non-operating items) Quality issues and mergers and acquisitions
➢ Mergers and acquisitions provide opportunities and
motivations to manage financial results.
Financial reporting that diverges from economic reality despite compliance with accounting rules
➢ An accounting treatment may conform to reporting standard,
but does not faithfully represent economic reality.
285

Evaluate the quality of a company’s financial report
Steps in evaluating the quality of financial reports
➢ Step 1: Understand the company, its industry, and the accounting principles it uses and why such principles are appropriate
➢ Step 2: Understand management including the terms of their compensation. Also evaluate any insider trades and related party transactions
➢ Step 3: Identify material areas of accounting that are vulnerable to subjectivity.
➢ Step 4: Make cross-sectional and time series comparisons of financial statements and important ratios.
286

Evaluate the quality of a company’s financial report
Steps in evaluating the quality of financial reports
➢ Step 5: Check for warning signs
➢ Step 6: For firms in multiple lines of business or for
multinational firms, check for shifting of profits or revenues to
a specific part of the business that the firm wants to highlight
➢ Step 7: Use quantitative tools to evaluate the likelihood of
misreporting.
287

Quantitative tools
Beneish model
➢ Beneish model is a probit regression model that estimates the probability of earnings manipulation using eight dependent variables.
➢ M-score > -1.78 indicates a higher than acceptable probability of earnings manipulation.
• Limitation: Beneish Model Relies on accounting data, may not
reflect economic reality.
288

Quantitative tools
Altman’s model
➢ Altman’s model is to assess the probability that a firm will file for bankruptcy
• Limitation:
✓ (1) The same as Beneish model.
✓ (2) Just a single-period static model
289

Summary
➢ Importance: ☆
➢ Content:
• 定性了解进行财务质量的分析流程
✓ Earnings quality (二级重点) ✓ Reporting quality
➢ Exam tips:
• 这部分知识比较繁杂，在考试中常常穿插在案例中与其
他概念混合考查。
290

Evaluating Quality of Financial Reports
Evaluate the Earnings Quality and Cash Flow, Balance Sheet Quality
Tasks:
➢ Describe the concept of sustainable (persistent) earnings.
➢ Explain potential problems that affect the quality of financial
reports.
291

Indicators of earnings quality
High-quality earnings are characterized by two elements
➢ Sustainable: high-quality earnings tend to persist in the future.
➢ Adequate: high-quality earnings cover the company’s cost of
capital.
Low-quality earnings come about due to:
➢ Earnings that are below the firm’s cost of capital ➢ Earnings that are not sustainable
➢ Poor reporting quality
292

Sustainable earnings
➢ Sustainable earnings
• Sustainable 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) .
293

Sustainable earnings
Sustainable earnings (Cont.)
➢ Earningst+1 = α + β1Earningst + ε
✓ A higher value of β1 indicates higher persistence of earnings.
➢ Earningst+1 = α + β1Cash flowt + β2Accrualst + ε
✓ Earnings can be viewed as being composed of a cash
component and an accruals component, the coefficient on cash flow (β1) has been shown to be higher than the coefficient on accruals (β2), indicating that the cash flow component of earnings is more persistent.
294

Mean Reversion
Mean reversion
➢ Mean reversion: Earnings at extreme levels revert back to normal levels over time
• A company experiencing poor earnings performance will shut down or minimize its losing operations and replace inferior managers with ones capable of executing an improved strategy, resulting in improved earnings.
• A company experiencing abnormally high profits will attract competition. New competitors may reduce their prices to gain a foothold in an existing company’s markets, thereby reducing the existing company’s profits over time.
• When earnings are largely comprised of accruals, Mean reversion will occur faster.
295

Evaluating the Earnings Quality of a Company
Two major contributions to earnings manipulation
➢ Revenue recognition issues
• Step 1: Understand the basics (analysis of disclosure)
• Step 2: Evaluate and question aging receivables
• Step 3: Cash versus accruals
• Step 4: Compare financial statement with physical data provided by
the company.
• Step 5: Evaluate revenue trends and compare with peers
• Step 6: Check for related party transactions
296

Evaluating the Earnings Quality of a Company
Two major contributions to earnings manipulation (Cont.)
➢ Expense recognition issues
✓ Step 1: Understand the basics (analysis of disclosure) ✓ Step 2: Trend and comparative (peer) analysis
✓ Step 3: Check for related party transactions
297

Indicators of Cash Flow Quality
Indicators of Cash Flow Quality
➢ High-quality cash flow is characterized by positive CFO that is derived from sustainable sources and is adequate to cover capital expenditures, dividends, and debt repayments
➢ Furthermore, high-quality CFO is characterized by lower volatility than that of the firm’s peers.
➢ Significant differences between CFO and earnings, or differences that widen over time, can be an indicator of earnings manipulation.
298

Evaluate the Cash Flow Quality
Evaluation of the statement of cash flows entails:
➢Checking for any unusual items or items that have not shown up in prior years.
➢Checking revenue quality (aggressive revenue) ➢Checking for strategic provisioning (non – cash expenses)
299

Indicators of Balance Sheet Quality
High-quality financial balance sheet reporting is evidenced by completeness, unbiased measurement and clarity of presentation ➢ Completeness of a balance sheet is compromised by the
existence of off-balance sheet liabilities such as incorrect use of
the operating lease classification.
➢ Clear presentation(clarity of presentation)
• While accounting standard specify which items should be included
in the B/S, they do not typically specify how such items must be presented.
✓ Single – line item or grouped together
300

Indicators of Balance Sheet Quality
➢ Unbiased Measurement, The balance sheet reflects
subjectivity in the measurement of several assets and liabilities:
• Value of the pension liability (based on several actuarial assumptions)
• Value of investment in debt or equity of other companies or which a market value is not readily available.
• Goodwill value (subjectivity in impairment testing)
• Inventory valuation (subjectivity in testing for impairment)
• Impairment of PP&E and other assets
301

Sources of Information About Risky
There are several sources of information about such risks:
➢ Financial statements
➢ Auditor’s report
➢ Notes to financial statements
➢ Management Discussion and Analysis (MD&A) ➢ SEC Forms
➢ Financial press (金融媒体)
302

Summary
➢ Importance: ☆
➢ Content:
• 定量分析上市公司盈利质量
• 定性分析现金流量表和资产负债表质量
➢ Exam tips:
• 这部分知识比较繁杂，在考试中常常穿插在案例中与其
他概念混合考查。
303

Integration of Financial Statement Analysis Techniques
Framework for Financial Analysis
Tasks:
➢ Demonstrate the use of a framework for the analysis of financial statements, given a particular problem, question, or purpose.
➢ Evaluate how a given change in accounting standards, methods, or assumptions affects financial statements and ratios.
304

Framework for Analysis of Financial Statement
Framework for Analysis
➢1、Define the purpose and context of the analysis Input:
• Analyst’ s perspective (evaluate a debt or equity investment, or establish a credit rating)
• Needs communicated by client or supervisor
• Institutional guidelines Output:
• Purpose statement and specific questions to be answered
• Nature and content of final report
• Timetable and budget
305

Framework for Analysis of Financial Statement
Framework for Analysis
➢2、Data collection Input:
• Financial statements
• Communication with management, suppliers,customers,
and competitors Output:
• Organized financial information
306

Framework for Analysis of Financial Statement
Framework for Analysis
➢3、Process data Input:
• Data from the previous phase Output:
• Adjusted financial statements
• Common-size statements
• Ratios
• Forecasts
307

Framework for Analysis of Financial Statement
Framework for Analysis
➢4、Analyze data Input:
• Data from the step 2 and 3 Output:
• Results
308

Framework for Analysis of Financial Statement
Framework for Analysis
➢5、Develop and communicate conclusions Input:
• Analytical results and previous reports
• Institutional guidelines for published reports Output:
• Report answering questions posed in step 1 • Recommendations
309

Framework for Analysis of Financial Statement
Framework for Analysis
➢ 6、Follow-up Input:
• Periodically update information Output:
• Update analysis and recommendations
310

Summary & Tips for Exam
• 分析师在进行财务分析时的基本流程
➢ Define the purpose and context of the analysis
➢ Data collection
➢ Process data
➢ Analysis of data
➢ Get conclusion
➢ Update
➢ TIPS:这部分知识在一级已经学过，只要求简单了解
即可。
311

How to Analyze
The analysis focuses on the following:
➢ Earnings sources and performance ➢ Asset base
➢ Capital structure
➢ Capital allocation decisions
➢ Earnings quality and cash flow analysis
➢ Market value decomposition
➢ Off-balance-sheet financing
➢ Anticipating changing accounting standards
312

Identify Financial Reporting Choices and Biases
Earnings sources and performance
➢ Return on equity (ROE) can be decomposed using the extended DuPont equation
Tax Burden
ROE = NI EBT
Interest EBIT Burden Margin
× EBT × EBIT × EBIT Revenue
Asset Turnover
Revenue Average assets
Financial Leverage
× Average assets Average equity
313

Identify Financial Reporting Choices and Biases
Earnings sources and performance
➢ Determine whether the firm‘s earnings are generated internally from operations or from externally.
➢ Adjustment
• Remove equity method income and the investment asset from the extended DuPont equation.
314

Identify Financial Reporting Choices and Biases
Example: Equity Method Adjustment
$in millions
2015
2014
2013
Revenue
$52,000
$48,300

EBIT
7,250
6,500

EBT
6,600
5,900

Equity income*
900
700

Net income
5,570
4,800

(* not included in EBT)
Total asset
$56,200
$49,900
$50,300
Equity investment
4,400
4,100
3,500
Stockholders’ equity
26,600
25,900
24,000
315

Identify Financial Reporting Choices and Biases
Example: Equity Method Adjustment
As reported
2015
2014
Tax burden
84.4%
81.4%
X interest burden
91.0%
90.8%
X EBITmargin
13.9%
13.5%
=net profit margin
10.7%
10.0%
X total asset turnover
0.98
0.96
X financial leverage
2.0
2.0
=ROE
21.0%
19.2%
316

Identify Financial Reporting Choices and Biases
Example: Equity Method Adjustment
317

Identify Financial Reporting Choices and Biases
Example: Equity Method Adjustment
318

Identify Financial Reporting Choices and Biases
Asset base
➢Examine the composition of the balance sheet assets over time.
• Presenting balance sheet items in a common-size format is
a useful starting point .
• Note the significance of goodwill(impairment,no amortization).
319

Identify Financial Reporting Choices and Biases
Capital structure
➢ The capital structure must support management’s strategic objectives and allow the firm to honor its future obligations.
➢ Liabilities such as employee benefit obligations, deferred taxes, restructuring provisions are less burdensome and may or may not require a cash outflow in the future.
320

Identify Financial Reporting Choices and Biases
Capital allocation decisions
➢ Consolidation can hide the individual characteristics of dissimilar subsidiaries.
➢ Firms are required to disaggregate financial information by segments to assist users.
➢ Segment disclosures are valuable in identifying:
• Revenue and profit by segment
• The relationship between capital expenditures and returns
• Segments that should be de-emphasized
321

Identify Financial Reporting Choices and Biases
Segment disclosure example
Revenue
EBIT
Seg
2015
2014
2015
2014
A
$270
20%
$220
20%
$60
29%
$50
27%
B
870
66%
820
66%
130
63%
120
65%
C
180
14%
170
14%
15
7%
15
8%
$1,320
$1,210
$205
$185
➢ Segment B contributes the highest revenue and EBIT while C contributes the lowest.
322

Identify Financial Reporting Choices and Biases
Segment disclosure example
Total Assets
Capital Expenditures
Seg
2015
2014
2015
2014
A
$370
36%
$170
21%
$10
15%
$9
17%
B
500
49%
490
60%
35
54%
30
56%
C
160
15%
150
19%
20
31%
15
28%
$1,030
$810
$65
$54
➢ Segment B has highest assets and capital expenditures ➢ Segment C has the lowest assets
➢ Segment A has the lowest capital expenditures
323

Identify Financial Reporting Choices and Biases
Segment disclosure example
➢ If ratio of proportional capex to proportional assets is greater than 1, Firm is growing the segment by allocating more resources to the segment.
➢ If ratio of proportional capex to proportional assets is less than 1, Firm is allocating less resources to the segment.
➢ If trend continues, the segment will become less significant over time.
324

Identify Financial Reporting Choices and Biases
Segment disclosure example
EBIT Margin
CapEx%/Assets%
Seg
2015
2014
2015
2014
A
22%
23%
0.42
0.81
B
15%
15%
1.10
0.93
C
8%
9%
2.07
1.47
➢ C has lowest EBIT margin and it is declining
➢ C’s proportional capex to proportional asset ratio is > 1
indicating over-allocation of resources to lowest margin segment.
325

Identify Financial Reporting Choices and Biases
Earnings quality
➢ Earnings quality refers to the persistence and sustainability of a firm’s earnings.
➢ Earnings can be disaggregated into cash flow and accruals using: • Balance sheet approach
• Cash flow statement approach
➢ Measure earnings quality using the ratio of accruals to average net operating assets, the lower the ratio, the higher the earnings quality.
326

Identify Financial Reporting Choices and Biases
Accruals ratio
➢ Balance sheet approach
• AccrualsBS = NOA END - NOA BEG
• Accruals ratioBS = (NOA END - NOA BEG) / [(NOA END + NOA BEG)*1/2]
• Net operating asset (NOA) is the difference between operating
assets and operating liabilities
✓ NOA = (Total assets – Cash – Marketable securities) – (Total
liabilities – Total debt)
➢ Cash flow statement approach
• AccrualsCF = NI-CFO-CFI
• Accruals ratioCF = (NI-CFO-CFI) / [(NOA END + NOA BEG)*1/2] 327

Identify Financial Reporting Choices and Biases
Cash flow analysis
➢ Adjustment
• Because of the potential for earnings manipulation by
increasing accruals, comparing operating cash flow to
operating income.
• Operating cash flow deducts interest and taxes while
operating income does not, adding-back cash interest and cash taxes.
328

Identify Financial Reporting Choices and Biases
Cash flow analysis
➢ Cash basis ratios
• Cash return on total assets = CFO / Average total assets • Cash flow to reinvestment = CFO / Capital expenditures • Cash flow to total debt = CFO before interest and taxes /
Total debt
• Cash flow interest coverage = CFO before interest and taxes
/ Cash interest
329

Identify Financial Reporting Choices and Biases
Market value decomposition
➢ The implied value
• The implied value is equal to the parent’s market value less
the parent’s pro-rata share of the associate’s market value.
• If the associate’s stock is traded on a foreign stock
exchange, it may be necessary to convert the market value
of the associate to the parent’s reporting currency. • Market capitalization of parent

• Parent’s share of associates’ market cap = implied value of parent
  330

  Identify Financial Reporting Choices and Biases
  Market value decomposition
  ➢ The implied P/E of the parent without associates Implied value of parent excluding associates
  Net income — Parent’s share of associates’ earnings
  ➢ It may be necessary to convert the associates’ earnings to the
  parent’s reporting currency using the average exchange rate.
  331

  Identify Financial Reporting Choices and Biases
  Market value decomposition example
  Thunderbird Corporation, located in the U.S., owns 30% of Eagle Company which is located in the U.K
  Thunderbird
  Eagle
  Market capitalization $60,000 ₤20,000
  Net income $5,000₤1,000CurrentFXrate($/₤) $1.70AverageFXrate($/₤) $1.60
  332

  Identify Financial Reporting Choices and Biases
  Implied Thunderbird value excluding Eagle
  Thunderbird market cap $60,000 - Share of Eagle $10,200 $49,800
  Implied Thunderbird net income excluding Eagle
  Thunderbird market cap $5,000 - Share of Eagle $480 $4,520
  Implied Thunderbird P/E
  Actual Thunderbird P/E
  11.0 ($49,800 /$4,520) 12.0 ($60,000 /$5,000)
  (₤20,000 X 30% X $1.70)
  (₤1,000 X 30% X $1.60)
  333

  Summary
  ➢ Importance: ☆ ☆
  ➢ Content:
  • 重点掌握在分析盈利质量时需要用到的定量方法
  • DuPont equation
  • Accruals ratio
  ✓ Balance sheet approach
  ✓ Cash flow statement approach
  • Cash flow analysis
  • Market value decomposition
  ➢ Exam tips:
  • 这部分知识在这个章节是最重要的，常常会考计算题，
  务必要求熟练掌握。
  334

  Integration of Financial Statement Analysis Techniques
  The Quality of Financial Data
  Tasks:
  ➢ Analyze and interpret how balance sheet modifications, earnings normalization, and cash flow statement related modifications affect a company’s financial statements, financial ratios, and overall financial condition.
  335

  Evaluate the quality of a company’s financial data
  Off-Balance-Sheet Financing (OBS)
  ➢ Operating lease V.S. Capital lease
  • For analytical purposes, treat an operating lease as a capital lease.
  • Assets and liabilities are initially increased by the same amount,
  Capitalizing an operating lease will increase financial leverage
  because of the increase in liabilities .
  • Remove rent expense (payment) from the income statement and
  replace with depreciation expense and interest expense.
  ➢ Other OBS techniques are debt guarantees, sales of receivable
  with recourse, take-or-pay agreement (照付不议条款).
  336

  Evaluate the quality of a company’s financial data
  Lease capitalization example
  Tex lnc. is the lessee in an operating lease. The PV of lease payments is $30 million discounted at an interest rate of 10%. The lease term is 6 years and the annual payment is $6.9 million.
  Adjust the following for the lease and calculate Tex’s total debt-to-equity and interest coverage ratios.
  Total Debt
  $100 million
  SH Equity
  $50 million
  EBIT
  $6 million
  Interest expense
  $2 million

  • Beginning of this fiscal year
    337

  Evaluate the quality of a company’s financial data
  Lease capitalization example
  ➢ Reported ratios: Debt/Equity
  Interest coverage
  ➢ Adjusted Ratios ($ in millions)
  2.0 3.0
  Total Debt
  SH Equity Adjusted D/E
  EBIT
  Interest Expense
  $130 ($100dent + $30 PV lease) $50
  2.6
  $7.9 $5.0
  [$6 EBIT + $6.9 PMT - ($30 / 6 Yrs)] [$2 Interest Exp + ($30 X 10%)]
  Adjusted coverage 1.6
  338

  Anticipating Changing Accounting standard
  Changes in accounting standards
  ➢ Be aware of proposed changes in accounting standards because of potential impact on the financial statements and valuation.
  339

  Anticipating Changing Accounting standard
  Example:
  • FASB is currently working on a proposal to potentially eliminate operating lease, if enacted, firms would be required to capitalize operating lease.
  • To avoid the increase in leverage from capitalizing a lease, the firm could raise additional equity, which dilute existing investors’ ownership interest.
  340

  Ratio analysis
  Ratio analysis is used to evaluate 5 basic facets of the company
  ➢ Internal liquidity
  ➢ Operating efficiency and profitability ➢ Risk profile: business and financial ➢ Growth potential
  ➢ External liquidity
  341

  Review of DuPont Analysis
  DuPont System: Extended Equation:
  342

  Review of Inventory analysis
  In periods of rising prices
  Statements
  LIFO
  FIFO
  Income statement
  Higher COGS
  Lower COGS
  Lower EBIT
  Higher EBIT
  Lower Tax
  Higher Tax
  Lower net income
  Higher net income
  Balance sheet
  Lower inventory balance
  Higher inventory balance
  Lower working capital
  Higher working capital
  Cash flow statement
  Higher CFO (Less tax paid)
  Lower CFO (More tax paid)
  343

  Review of Inventory analysis
  In periods of rising prices
  Ratios
  LIFO
  FIFO
  Profitability
  Lower gross and net margins
  Higher gross and net margins
  Liquidity
  Lower current ratio
  Higher current ratio
  Solvency
  Higher D/A and D/E
  Lower D/A and D/E
  Activity
  Higher inventory turnover
  Lower inventory turnover
  344

  Review of Long-lived asset analysis
  Capitalizing vs. Expensing
  Statements
  Items
  Capitalizing
  Expensing
  B/S & Ratios
  Total assets
  Higher
  Lower
  Total equity
  Higher
  Lower
  Leverage ratio (D/A, D/E)
  Lower
  Higher
  I/S & Ratios
  Net Income volatility
  Lower
  Higher
  Net income – first year (ROA, ROE)
  Higher
  Lower
  Net income – later year (ROA, ROE)
  Lower
  Higher
  Cash flow statement
  Total cash flow
  Same
  Same
  CFO
  Higher
  Lower
  CFI
  Lower
  Higher
  345

  Conservative & Aggressive Accounting
  Aggressive
  Conservative
  Capitalizing current period costs
  Expensing current period costs
  Longer estimates of the lives of depreciable assets
  Shorter estimates of the lives of depreciable assets
  Higher estimates of salvage values
  Lower estimates of salvage values
  Straight-line depreciation
  Accelerated depreciation
  Delayed recognition of impairments
  Early recognition of impairments
  Less accrual of reserves for bad debt
  More accrual of reserves for bad debt
  Smaller valuation allowances on DTA
  Larger valuation allowances on DTA
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  Summary
  ➢ Importance: ☆
  ➢ Content:
  • 掌握在财务报表数据调整的方法
  ✓ Off-Balance-Sheet data
  ✓ Changes in accounting standards ✓ Ratio analysis
  ➢ Exam tips:
  • 这部分知识和一级已经学习过的知识存在穿插，介于二级可能还
  会出现一级中协会默认考生已掌握的知识点，有必要针对一级的 重要知识点进行复习。(尤其是长期资产和存货，虽然17年开始 在考纲中被删减掉了，但仍然可能在具体的场景分析中被考到。
  347

  Analysis of Financial Institutions
  Financial Institutions and Financial Regulations
  Tasks:
  ➢ Describe how financial institutions differ from other companies;
  ➢ Describe key aspects of financial regulations of financial institutions;
  348

  Financial Institutions
  Financial Institutions
  ➢ Serve as intermediaries between providers and recipients of capital.
  ➢ Facilitate asset and risk management.
  ➢ Execute transactions involving cash, securities, and other
  financial assets.
  349

  Financial Institutions
  Types of financial institutions
  ➢ Commercial banks: deposit-taking, loan-making institutions.
  ➢ Others: investment banks, credit card companies, brokers, dealers, exchanges, clearing houses, depositories, investment managers, financial advisers, and insurance companies.
  350

  Financial Institutions
  Features of financial institutions ➢ Systemic importance
  ✓Smooth functioning is essential to the overall health of an economy.
  ✓Systemic risk.
  ✓Heavily regulated. ➢ Accounts
  ✓Liabilities: deposits primarily. ✓Assets: financial assets predominantly.
  (exposure to a different set of risks) 351

  Financial Regulations
  Reasons for establishment of global regulatory bodies
  ➢ Global systemic risk.
  ➢ Harmonization and globalization of regulatory rules,
  standards, and oversight.
  Basel Committee
  ➢ Focused on financial stability.
  ➢ Hosted and supported by the Bank for International
  Settlements.
  ➢ Members include central banks and entities responsible for
  supervising banks.
  352

  Basel III
  Basel III
  ➢ The Basel Committee developed the international regulatory framework for banks known as Basel III, which is the enhanced framework succeeding Basel I and Basel II.
  Purposes
  ➢ Improve the banking sector’s ability to absorb shocks arising from financial and economic stress.
  ➢ Improve risk management and governance.
  ➢ Strengthen banks’ transparency and disclosures.
  353

  Basel III
  Three important highlights
  Highlights
  Significance
  minimum capital requirement
  prevent a bank from assuming so much financial leverage that it is unable to withstand loan losses
  minimum liquidity requirement
  ensure that a bank would have enough cash to cover a partial loss of funding sources or a cash outflow resulting from off-balance-sheet funding commitments
  stable funding requirement
  relate liquidity needs of the financial institution’s assets to liquidity provided by the funding sources
  354

  Summary & Tips for Exam
  ➢ 金融机构与其他机构的区别 ➢ 巴塞尔委员会(了解)
  ➢ TIPS:主要从定性角度对知识点加以把握。
  355

  Analysis of Financial Institutions
  Analyzing a bank
  Tasks:
  ➢ Explain the CAMELS approach to analyzing a bank, including key ratios and its limitations;
  ➢ Describe other factors to consider in analyzing a bank;
  ➢ Analyze a bank based on financial statements and other factors
  356

  Analyzing a bank
  Bank
  ➢ Entities whose primary business activities are taking deposits and making loans.
  The CAMELS Approach
  ➢ An approach widely used as a starting point to analyze a bank.
  ➢ The six components are Capital adequacy, Asset quality, Management capabilities, Earnings sufficiency, Liquidity position, and Sensitivity to market risk.
  357

  The CAMELS Approach
  Procedure
  ➢ Step1: Use the CAMELS approach to evaluate a bank. ➢ Step2: Assign a numerical rating of 1 through 5 to each
  component.
  ✓Rating 1 : best practices in risk management and
  performance.
  ✓Rating 5: poorest performance and risk management
  practices.
  ➢ Step 3: Composite rating for the entire bank is constructed.
  ✓Not a simple arithmetic mean.
  ✓Each component is weighted by the examiner(judgment
  involved).
  358

  The CAMELS Approach-C
  Capacity Adequacy
  ➢ The proportion of the bank’s assets funded with capital.
  ➢ Assets: assets are adjusted based on risk, with riskier assets
  requiring a higher weighting(weightings are specified by individual countries’ regulator).
  Capital: capital is classified into hierarchical tiers.
  ➢ Indicate that whether a bank has enough capital to absorb potential losses without severely damaging its financial position.
  359

  The CAMELS Approach-C
  Assets
  ➢ Example: consider a hypothetical bank with three assets: $10 in cash
  $1,000 in performing loans
  $10 in non-performing loans.
  Assume weights are specified 0%, 100% and 150% respectively.
  Then,
  The bank’s risk-weighted assets (RWAs) =
  ($10 × 0%) + ($1,000 × 100%) + ($10 × 150%) = $1,015. 360

  The CAMELS Approach-C
  Capital—Common Equity Tier 1 Capital
  ➢ Requirement:
  ✓Common Equity Tier 1 Capital must be at least 4.5% of risk-
  weighted assets.
  ➢ Contents:
  ✓Common stock, issuance surplus related to common stock ✓Retained earnings, accumulated other comprehensive
  income
  ✓Certain adjustments
  361

  The CAMELS Approach-C
  Capital-Total Tier 1 Capital
  ➢ Requirements:
  ✓Total Tier 1 Capital must be at least 6.0% of risk-weighted
  assets. ➢ Contents:
  ✓Common Equity Tier 1 Capital
  ✓Other Tier 1 Capital: for example, the instruments be
  subordinate to such obligations as deposits and other debt obligations, not have a fixed maturity, and not have any type of payment of dividends or interest that is not totally at the discretion of the bank.
  362

  The CAMELS Approach-C
  Capital-Total Capital
  ➢ Requirements:
  ✓Total Capital must be at least 8.0% of risk-weighted assets.
  ➢ Contents:
  ✓Total Tier 1 Capital.
  ✓Tier 2 Capital: instruments that are subordinate to
  depositors and to general creditors of the bank, have an original minimum maturity of five years, and meet certain other requirements.
  363

  The CAMELS Approach-A
  Asset Quality
  ➢ From the perspective of the composition of a bank’s assets. What proportion of total assets was invested in highly liquid assets?
  ➢ From the perspective of credit quality.
  Two dimensions in analyzing asset quality for loans:
  ✓Creditworthiness of the borrowers.
  ✓Adequacy of adjustments for expected loan losses.
  364

  The CAMELS Approach-M
  Management Capabilities
  ➢ Effective management:
  successfully identifying and exploiting profit opportunities simultaneously managing risk
  ➢ Indicators of management effectiveness: ✓ Internal controls
  ✓ Management communication
  ✓ Financial reporting quality
  ✓ Overall performance (the most reliable indicator)
  365

  The CAMELS Approach-E
  Earnings
  ➢ Adequate return on capital
  ➢ Earnings be high quality and trending upward ➢ Accounting estimates are unbiased
  ➢ Earnings are derived from sustainable items
  366

  The CAMELS Approach-E
  Earnings
  ➢ Major composition of bank’s earnings: (a) net interest income
  (b) service income
  © trading income
  A greater proportion of net interest income and service
  income is typically more sustainable than trading income. ➢ Other considerations for banks:
  ✓Estimation of loan impairment allowances
  ✓Fair value of financial assets and liabilities 367

  The CAMELS Approach-L
  Liquidity Position—LCR
  ➢ Liquidity Coverage Ratio (LCR) is expressed as the minimum percentage of a bank’s expected cash outflows that must be held in highly liquid assets.
  ➢ Expected cash outflows (the denominator) are the bank’s anticipated one-month liquidity needs in a stress scenario
  ➢ Highly liquid assets (the numerator)include only those that are easily convertible into cash.
  ➢ Minimum: 100%.
  368

  The CAMELS Approach-L
  Liquidity Position—NSFR
  ➢ Net Stable Funding Ratio is expressed as the minimum percentage of a bank’s required stable funding that must be sourced from available stable funding.
  ➢ Required stable funding (the denominator) is a function of the composition and maturity of a bank’s asset base.
  ➢ Available stable funding (the numerator) is a function of the composition and maturity of a bank’s funding sources (i.e., capital and deposits and other liabilities).
  369

  The CAMELS Approach-L
  Liquidity Position—NSFR
  ➢ The ratio relates the liquidity needs of the financial institution’s assets to the liquidity provided by the funding sources.
  ➢ Minimum: 100%.
  370

  The CAMELS Approach-S
  Sensitivity to Market Risk
  ➢ Exposures to market movements:
  ✓Mismatches in the maturity of banks’ loans and deposits ✓Repricing frequency
  ✓Reference rates
  ✓Currency
  ➢ Typical Indicator—VAR
  a way to estimate the amount of potential loss based on simulations that incorporate historical pricing information.
  371

  Other Factors
  Banking-Specific Considerations
  Considerations for any company
  Government support
  Competitive environment
  Government ownership
  Off-balance-sheet items
  Mission of banking entity
  Segment information
  Corporate culture
  Currency exposure
  Risk factors
  372

  Summary & Tips for Exam
  ➢ 银行分析—CAMELS approach
  ➢ TIPS:掌握CAMELS各个组成部分。
  373

  Analysis of Financial Institutions
  Analyzing an insurance company
  Tasks:
  ➢ Describe key ratios and other factors to consider in analyzing an insurance company;
  374

  Insurance Companies
  Attributes
  ➢ Provide protection against adverse events.
  ➢ Earn revenues from premiums(amounts paid by the
  purchaser of insurance products) and from investment income earned on the float (amounts collected as premium and not yet paid out as benefits).
  Types
  ➢ Property and casualty insurance companies(P&C insurers). ➢ (L&H insurers) .
  375

  Insurance Companies
  Types
  P&C
  L&H
  contract duration
  short term
  long term
  variability of claims
  claims are more variable and “lumpier”
  claims are more predictable
  business profile
  protect against loss or damage to property
  provide benefit upon death
  provide a savings vehicle
  investment returns
  conservative
  seek higher returns
  liquidity
  higher degree
  capitalization
  lower capital requirements
  376

  Insurance Companies
  Analysis of P&C companies’ profitability
  ➢ Loss and loss adjustment expense ratio Calculation:
  ✓(Loss expense + Loss adjustment expense)/Net premiums earned
  Indication:
  ✓Degree of success in estimating risks insured Judgment:
  ✓The lower the ratio, the greater the success
  377

  Insurance Companies
  Analysis of P&C companies’ profitability
  ➢ Underwriting expense ratio Calculation:
  ✓Underwriting expense/Net premiums written Indication:
  ✓Efficiency of money spent in obtaining new premiums Judgment:
  ✓The lower the ratio, the greater the success
  378

  Insurance Companies
  Analysis of P&C companies’ profitability
  ➢ Combined ratio Calculation:
  ✓Loss and loss adjustment expense ratio + Underwriting expense ratio
  Indication:
  ✓Overall efficiency of an underwriting operation Judgment:
  ✓A combined ratio of less than 100 is considered efficient.
  379

  Summary & Tips for Exam
  ➢ 巴塞尔委员会(了解)
  ➢ 银行分析—CAMELS approach ➢ 保险公司分析—P&C VS L&H
  ➢ TIPS:这部分是考纲新增内容，实务性较强，主要从定 性角度对知识点加以把握。
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