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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

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