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Concepts

Description

Categories of intercorporate
investments

Ownership

Intercorporate Investments
Degree of influence

< 20% (Investment in financial assets)

No significant influence

Held to maturity (debt)
Available for sale (debt + eqt)
FVTPL (debt + eqt)

20% - 50%

Significant influence

Equity method

> 50%

Control

Acquisition method

Investment in financial assets Classification

Accounting treatment (current)

Held-to-maturity

FVTPL

Available-for-sale

Balance sheet

- Amortised cost (PV of future CF)

- Fair value

- Fair value

Income statement

- Interest

- Interest;
- Dividend;
- Realised gain/loss
- Unrealised gain/loss

- Interest;
- Dividend;
- Realised gain/loss
- Unrealised gain/loss for debt securities (IFRS)
- Unrealised gain/loss for equity securities
- Unrealised gain/loss for debt securities (US
GAAP)

OCI

investment in financial assets Reclassification

From

To

Accounting treatment

Note

FVTPL

Others

Unrealisd Gain / Loss are recognised into PL

Permitted under IFRS

Held to maturity

FVTPL

Unrealisd Gain / Loss are recognised into PL

Permitted under IFRS

Held to maturity

Available for sale

Carrying value is remeasured @ FV, difference recorded in OCI

Available for sale

FVTPL

Transfer unrealised Gain / Loss from OCI to PL

Available for sale

Held to maturity

Amortised Gain / Loss previosly recorded in OCI

Permitted under IFRS

*All transfers @ FV on transfer date
Investment in financial assets Impairment

US GAAP

IFRS

Impairment of financial assets
- Recovered value < carrying value
- Decline in value is expected to be other than temporary

Impairment of financial assets
- If at least 1 loss event has occurred
- its effect on the security's future CF can be estimated reliably
- Loss event for debt securities :
+ default on payment;
+ likely bankruptcy or reorganisation of the issuer
+ concessions from the bondholders (credit rating downgrade is not an indication)
- Loss event for equity securities :
+ substantial / extended decline of security's FV below its carrying value
+ change in the business environment of the equity issuers → equity value unlikely to
recover to its initial cost (econ, legal, technological changes)
Impairment reversal - permit for debt securities only

Impairment reversal - not allow
Investment in financial assets Analysis

- Important to separate the firm's operating results from investment results
- Using market value for financial assets
- Necessary to remove non-operating assets when calculating return on operating assets ratio
- Must assess the effects of investment classification on reported performance
...
Investment - Cr
...
Investment

- Reclassification of debt securities is
permitted only if business model has
changed

Investment in associates Impairment

US GAAP : FV of investment < carrying value; decline is considered permanent → wri en down to FV
IFRS : One or more loss event → wri en down to FV
Loss is recorded in PL
No written-up is permitted under both IFRS and US GAAP

Investment in associates Transaction with the investee

Profit from these transactions must be deffered until the profit is confirmed through use / sale to 3rd party

Investment in associates Analytical issues

- should consider the appropriateness of the equity method
- Equity method ignore investee's debt → lower leverage
- Proportionate share of investee's earnings is recorded in investor's PL, but might not be available to the investor in form of CF

Business combination

IFRS : no differentiate
US GAAP
- Merger : A absorb B ; B cease to exist
- Acquisition : Parent-subsidiary relationship
- Consolidation : New entity absorb both A & B
Acquisition method is required both under IFRS and US GAAP
...
At-risk equity that is insufficient o finance the entity's activities without additional financial support
2
...
g
...
Same net income
2
...
Acquisition method : higher equity due to NCI
3
...
Acquisition method revenue & expenses > Proportionate consolidation method revenue & expenses > Equity method revenue & expenses

Concepts
Defined contribution plan /
Defined benefit plan

Defined benefit plan - Funded
status of the plan

Description
Employee Compensation : Post-employment and Share-based
Defined contribution plan
Defined benefit plan
- Firm contribute certain sum each period to employee's retirement account
- Firm promises to make periodic payment to employee after retirement
- Firm makes no promise to employee regarding FV of plan assets
- Employee assumes investment risk
- Employee make investment deision
- Employee assumes all investment risk
Funded status = FV of plan assets - Projected benefit obligation
Overfunded : Plan assets > pension obligation
Underfunded : Plan assets < pension obligation

Plan assets

PBO

Beginning FV
(+) Contributions
(+) Actual return
(-) Benefit paid
--------------------------------= Ending FV

Beginning PBO
(+) Service cost
(+) Interest cost
(+) Past service cost
(+/-) Actuarial losses/gains
(-) Benefits paid
--------------------------------= Ending PBO

Funded status
Defined benefit plan - Projected
benefit obligation (PBO)

Actuarial PV of all future pension benefits earned to date, based on expected future salary increase

1
...
Interest cost = Beginning pension obligation × discount rate
3
...
Change in actuarial assumpion : Actuarial gain / loss
5
...
Gross vs
...
Difference in assumptions
3
...
Difference in classification in PL
* US GAAP : total periodic pension cost is operating expense
* IFRS : components are included in various line items
* Adjust US GAAP into IFRS :
- add back periodic pension cost in PL
- subtract only service cost in determining operating income
- Interest cost : add to interest expense
- Actual return on plan assets : add to non-operating income
- Ignore any amortisation

Defined benefit plan - Disclosure CF Contribution > Obligation ≈ principal prepayment on loan
related information
Contribution < Obligation ≈ source of borrowing
Material difference between Contribution and Obligation → reclassify from CFO to CFF
Issues with accounting for share1
...
Shares/options might be granted with contigencies (e
...
: cannot be sold for a period of time) → compensa on expense is spread over the perod which they reweard the employee

Stock option

Calculated based on :
- FV of options @ grant date
- Number of options expected to be vested
- Time between the grant date and he vesting date
Stock option compensation expenses decrease net income ; increase paid-in capital → no change to total equity
Method to determine FV of options:
- Based on observable market price of similar option
- Use option-pricing model (Black-Scholes; binominal model)
...
GAAP / IFRS compliance and decision-useful + high quality earnings
2
...
GAAP / IFRS compliance but not decision-useful (biased choises)
4
...
Fraudulent accounting

Issues that affect the quality of FR

1
...
Classification issues - how individual FS element is categorised
- Removing AR by selling / transferring AR balance to related-parties, or treating them as LT → ↓ DSO, ↑ Receivable turnover
...
Mistate
profitability

- Aggressive revenue recognition (channel stuffing, bill and hold,
outright fake sales)
- Lessors use finance lease classification
- Classify non-operating revenue as operating revenue / operating
expenses as non-operating expenses
- Classify gains thru NI, but losses thru OCI

- Higher revenue growth than peers
- Receivable growth > Revenue growth
- High rate of customer returns
- High prorportion of revenue in Q4
- Unexplained increase in OM
- CFO < Operating income
- Inconsistence in operating vs
...
Mistate assets /
liabilities

- Choosing inapproprite model / inputs → affect es mated values of FS
elements
- Reclassification from ST to LT
- Over / Understating allowances and reserves
- Undetstating identifiable assets (overstating GW) in acquisition
method

- Inconsistence model inputs for valuating assets and liabilities
- Typical ST assets are classified as LT
- Allowances and reserves differ from peers, and fluctuate over time
- High GW relative to total assets
- Use of Special purpose entities
- Large fluctuations in DTA / DTL
- Large off-BS items

- Managing activitie to affect CFO (delay payments, sell AR)
- Misclassify CFI as CFO

- ↑ AP, but ↓ AR and inventory
- Capitalied expenditures
- Increase bank overdraft

3
...
Evaluate any insider trades, and RPTs
Step 3 : Identify material areas of accounting that ar vulnerable to subjectivity
Step 4 : Make cross-sectional and time-series comparisons
Step 5 : Check for warning signs
Step 6 : For firms with multiple lines of business / or mltinational firms - check for shifting of profts / revenues to a specific parts of the business that the firm wants to hightlight
Step 7 : Use quantitative tools to evaluate the likelyhood of misreporting

Quantitative tools - Beneish model Beneish model : estimate the probability of earnings manipulation
...
78 → higher than acceptable probability of earning manipula on

𝑀 𝑠𝑐𝑜𝑟𝑒 = −4
...
920 × 𝐷𝑆𝑅𝐼 + 0
...
404 × 𝐴𝑄𝐼 + 0
...
115 × 𝐷𝐸𝑃𝐼 − 0
...
679 × 𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠 − 0
...
𝑖𝑛𝑑𝑒𝑥 =

𝑆𝐺𝐴𝐼 𝑆𝐺𝐴 𝑖𝑛𝑑𝑒𝑥 =

𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠 =

𝑆𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠

𝐷𝑒𝑝𝑟
...
𝑟𝑎𝑡𝑒

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

∗ 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝐴𝑄𝐼 𝑖𝑛𝑑𝑖𝑐𝑎𝑡𝑒 𝑒𝑥𝑐𝑒𝑠𝑠𝑖𝑣𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

∗ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑐𝑜𝑚𝑝𝑎𝑛𝑖𝑒𝑠 ℎ𝑎𝑣𝑒 𝑚𝑜𝑟𝑒 𝑝𝑟𝑒𝑠𝑠𝑢𝑟𝑒 𝑡𝑜 𝑚𝑎𝑛𝑖𝑢𝑙𝑎𝑡𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑡𝑜 𝑚𝑒𝑒𝑡 𝑒𝑥𝑝𝑒𝑐𝑡𝑎𝑡𝑖𝑜𝑛𝑠
𝐷𝑒𝑝𝑟
...
𝑒𝑥𝑝

𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐𝑎𝑙 𝑐𝑜𝑠𝑡

∗ 𝐷𝐸𝑃𝐼 > 1 𝑖𝑛𝑑𝑖𝑐𝑎𝑡𝑒 𝑠𝑙𝑜𝑤𝑒𝑟 𝑑𝑒𝑝𝑟
...
Sustainable : Recurring in the future
...
g
...
Adequate : earning cover he company's cost of capital

Mean reversion

Mean reversion : earnings @ extreme levels tend to revert back to normal levels over time
→ Shoud not expect extreme earnings to con nue indefinitely
More accruals → faster reversion

Earnings manipulation contributors 1
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Expenses capitalisation
- Capitalising operating expenses → increase reported performance
- Warning sign : %PPE in common size BS increase overtime
- Steps in expenses recognition analysis :
+ Step 1 : Understand the cost capitalisation policies; gather info about depreciation policies and how they compare with peers
+ Step 2 : Trend and comparative analysis
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Completeness :
- Reduce the existence of off-BS liabilities due to:
+ Incorrect use of Operating lease classification
+ Take-or-Pay purchase agreement
- EQT conso method result in certain profitability ratios higher than acquisition method, especially in firms with many near-50% subs
2
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Clear presentation : present items as single-line or groups
...
g
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Sources of earnings and ROE
on the quality and comparability of DuPont equation : ROE = Tax burden x Interest burden x EBIT margin x Total asset turnover x Financial leverage
FS
→ iden fy performance driver, weaker areas that are covered by other stronger areas
Consider firm's source of income internally generated (more control) vs externally generated (income generated by ownership of interest in associate - less control) → eliminate equity
income to analyse the performance from the firm's own asset base
2
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Capital structure : Must be able to support the strategic objectives + meet the future obligations
- Analyse thru financial leverage ratios
- Some liabilities are more burdensome than others (e
...
: Financial and bond liabilities default if not paid on time, or non-compliant with covenants; employees obligations, deferred taxed,
restructuring provisions are less burdensome, and may not require future cash outflow
4
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Eaning quality and CF analysis
Step 1 : Accruals ratio (Accruals / Average net operating assets) : used to measure eanings quality
...
2 approaches:
a
...
CF approach :
𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠
𝑁𝐼 − 𝐶𝐹𝑂 − 𝐶𝐹𝐼
=
(𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠
+ 𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠
)
(𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠
+ 𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠
2
- Wide fluctuation → indica on of earning manipula on by increasing accruals → compare CF to opera ng income
Step 2 : Compare CF to operating income
𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠 𝑟𝑎𝑡𝑖𝑜𝑠 =

𝐶𝑎𝑠ℎ 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑒𝑑 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 (𝐶𝐺𝑂) 𝐸𝐵𝐼𝑇 + 𝑁𝑜𝑛 − 𝑐𝑎𝑠ℎ 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝
Step 3 : Examine cash return on total assets from acquisition
=
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝐶𝐺𝑂
𝐶𝐺𝑂
𝐶𝐺𝑂
𝐶𝐹 𝑡𝑜 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
𝐶𝐹 𝑡𝑜 𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 =
𝐶𝐹 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐶𝐴𝑃𝐸𝑋
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝐶𝑎𝑠ℎ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑
2
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Off-BS financing (Most common form is operating lease)
For analytical purpose : Operating lease shoud be treated as finance lease
→ BS : increase assets and liabili es by PV of remaining lease payments→ increase leverage
→ PL : replace rental expense with deprecia on expenses and interest expense → lower NI in early years → decrease interest coverage ra o
2

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