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less than 20%, no significant influences

Investment in financial asset Held-to-maturity, available for sale,


(minority passive) fair value through profit or loss

Overview 20-50%, significant influence


Investment in associate equity methods

More than 50%, Control


Business combinations Acquisition method

Held-to-maturity

Available for sale


Categories Held for trading
Fair value through P/L
Designated at fair value

IFRS: DOES NOT allow reclassification in/out of designated


at fair value, RESTRICTED reclassification OUT of HFT
Reclassification example

HTM, AFS: Must impair

Under US. GAAP: Impair if decline


in value is not temporary

Debt: default, bankruptcy,


concession from bondholder,
reorganization of issuer, NOT
Under IFFRS: Impair if at least one INCLUDE rating downgrade, lack of
loss event has occurred and its liquid market for debt...
1.
effect on future CF can be
Investment Equity: if stock experiences
estimated reliably Loss event:
in financial substantial or extended below its
asset carrying value that 's hard to
Impairment recover.

HTM -> impair to PV of est future


Impair: CF @ rate that used @ purchase.

Both USGAAP & IFRS require to


evaluate each accounting period

IFRS ok
Debt
USGAAP no
Reversal of impairment
Intercorporate Equity Both IFRS & USGAAP no
investment

Separate operating & investment result

Use market value for comparison


Analysis of investment in Calculate return on operating asset
financial asset (removing investment result)

Defect misclassification

equity investment is recorded at


cost on investor's BS -> non
Initially current asset

the
increase/decrease
proportionate
the investment
share of
account If decrease to 0 ->
investee's
Equity method earning/loss is recognized in the investor's IS ->
not operating income

In subsequent periods Dividends


received
from the are treated as return of capital reduce the investment account
investee
are not recognized in the investor's IS

2. Goodwil = purchase price - fair value


Investment
Excess of purchase price over BV Additional Depreciation =
in
associate
US GAAP: when BV> fair value &
the decline is permanent

Impairment of investment in associate IFRS: need to have evidence of at


least 1 loss event -> no writeup

Upstream
Transaction with investee ->
deduct unconfirmed profit from Downstream
equity income

If investee makes profits & div


payput < 100%-> equity method
has hihger earning than minority
passive

investee's debt
Analytical issues for investment in associates Ignore
investee's revenue

Intercorporate investment.mmap - 1/15/2017 - Mindjet


Under IFRS: No
categories

Merger: A +B = A

Acquisition: A+B = AB
Categories Under US GAAP:
Consolidation

SPE

or known as uniting of interests method (IFRS)

2 firms are combined using historical book values

operating results for prior period are restated


as though 2 firms were always combined
The pooling of
interest ownership interest continue, and former
methods accounting bases are maintained

fair value plays no role


3.
Business eliminated now
combination
all of asset, liab, rev, exp of subsidiary are
combined with parent

intercompany transaction are excluded

Full goodwill =

partial goodwill =

IFRS:if carrying value of cash generating unit >


Under recoverable amount -> impair
acquisition & Goodwill
consolidation 1st step: Carrying value of
reporting unit > FV ->
method G/W impairment
impair
USGAAP:
2nd: loss = carrying value of GW -
implied FV of GW -> loss in IS
Intercorporate
Bargain purchase: if purchase price < fair value
investment -> IFRS & USGAAP require to report a gain in
IS

Shared by 2 investors or more

Definition Often used to invest in foreign markets,


special projects or risky ventures

Both USGAAP & IFRS require equity


Joint venture method of accounting

Proportionate is similar to acquisition method


except will only report the proportion of the
In rare cases: proportionate
asset, liab rev, exp & NO minority interest
consolidation method is allowed
under USGAAP & IFRS

Special purpose entity

a leal structure (corporation, partnership, joint venture, trust)


SPE
To isolate asset & lliad to reduce risk and
lower financing cost

Variable interest entity


SPE & VIE At risk equity is insufficient to finance the
entity activities without additional support

decision making rights


VIE = SPE + conditions
Equity investor lacks obligation to absorb losses

right to receive residual interest in the SPE

must consolidate

Items
Effect on financial ratio
Ratio

Intercorporate investment (2).mmap - 1/15/2017 - Mindjet


firm make no promise about future value of
planassets; employees assume all investment risk'

Defined-contribution plan: Pension expense = firm's contribution, not future


obligation to report

firm promise to make periodic payment to the employee


a. Types of based on number of year service, employee compensation...
post-employment Defined-benefit plan employer assumes investment risk
benefit plans

e.g.: primary healthcare benefit for


retired employees

similar to defined-benefit plan as future benefit defined today


Other post-employment benefit based on unknown variables, but are the funding status is different (
expense is recognized as benefits are earned but CF is not affected
until actually to be paid to employee)

actuarial PV of all pension benefit


earned to date

PBO: Under IFRS: call PVDBO take g into consideration

going concern, working till retire

Beginning PBO

+Current service cost = PV of benefits earned by employee


during current period

+ Interest cost:increase in PBO due


to passage of time = PBO beg of period * discount rate

Due to: initiate/amend/terminate


PBO=
& curtail a plan

Past/prior service cost=retroactive


benefit awarded to employee'
b. Measures +Past service cost
of a DB IFRS: expense
pension
USAGAAP: amortized over average
plan's liab,
service life of employees
asset
-/+ actuarial G/L : change in
mortality, retirement age, discount
rate, turnover

- Benefit paid when company pays pension to employee

Plan asset = PA beg + contribution + actuarial return - benefit paid


Employee
Compensation > 0: overfunded -> report asset on
BS of employer which is subject to
a ceiling of pv of futute economic
benefits such as future refunds or
reduced contributions
Funded status Formula: = PA - PBO < 0: underfunded -> report liab on
BS of employer

Underfunded

+ current service cost

+interest cost

not affect PBO but reduce pension expense


USGAAP
- expected return on assets expected return can be different
interest return from discount rate

= discount rate * funded status


IFRS +/- interest expense/income
expected return is always equal to discount rate

Periodic Recorded in OCI


pension loss due to change in actuarial assumption
cost
2 component different btw discount rate &
reported
in P/L = expected return on asset
actuarial G/L
-/+ amortization of actuarial G/L
DB pension cost USGAAP
10% corridor approach

IFRS not amortized

US GAAP amortized -> goes to OCI & is amortized

past service cost IFRS: recognize as expense


immediately

Total/Net ( or economic) Formula:


periodic pension cost

USGAAP aggregated & presented as a sigle line item

IFRS maybe presented seperately


Presentation

Both

Employee Compensation.mmap - 1/15/2017 - Mindjet


PBO ___

current service cost ____, interest


discount rate cost ____, expected return____,
pension exp_____

PBO _____

Current service cost _____,


rate of compensation grow interest cost ______, expected
Impact return______, pension expense
of a ________
DBP's
assumption
PBO______

Current service cost _____, interest


expected rate of return increase cost ______, expected return______,
pension expense ________

similar except healthcare inflation


rate replaces compensation growth
rates
other post-employment benefits

1. Gross vs net pension


asset/liab

Adjustment 2. Differences in assumption used


for
analytical 3. IFRS vs USGAAP -> use
purpose comprehensive income

4. Different due to classification


in income statement

Funded pension plan:


contribution =

Unfunded plan: benefit paid =


Employee
Compensation
Cash flow information If contribution much lower than
econ pension expense ->>

IF contribution much higher than


For analytical purpose econ pension expense ->>

e.g..

Problem in estimating stock price (


not public share)/stock option
(stock grant)

Share /Option granted with contingencies:


estimated expense may be spread over a
Accounting issues period of time from grant date to when
employee can exercise the option (service
period)

Without conditions

Restricted stocks: cant be sold till


end of vesting
Outright stock grants
Performance stocks: contingent on
Share-based compensation meeting performance goals ->
easily to be manipulated

Condition: share price increase


over a threshold

Grant stock Payment Cash or equity or both


Stock appreciation right
-> no dilution for existing
shareholder, unlimited upside/
limited downside for employee

Phantom Stocks: stock


appreciation for privately
held/highly illiquid firms -> based
on performance of hypothetical
stock

Employee compensation 2.mmap - 3/13/2017 - Mindjet


Local currency

determined by management

currency of the primary economic


environment in which entity
operates

the currency in which the entity


generates & expends cash

a. Distinguish Functional currency currency that influences sales price


for goods & services

currency of the main competitive


forces & regulations

influences labor, material

receipt from operating activities,

Parent company
Presentation (reporting) currency

b. Foreign currency transaction exposure

if functional = presentation currency


Remeasurement -Temporal methods subsidiary is well intergrated with parent

if functional # presentation currency

Translation - Current rate methods subsidiary is independent,


decentralized from parent

All income statement account:


average rate
Multinational All balance sheet account: current
operation (part rate ( rate on balance sheet date),
1) except for common stocks using
Current rate methods historical rate at issuance.

Dividend: the rate applied when declared

Plug number: CTA ( cumulative translation


adjustment) is reported as part of equity

Monetary asset & liab (cash,


receivable, payables, ST, LT debt) .:
Rules for
current rate
c.d applying which
Translation rate for Non monetary asset & liab ( fixed
methods for translation asset, intangible asset, unearned
subsidiary revenue, inventory): historical rate

Common stock & dividend:


historical rate
Temporal methods Expense related to nonmonetary
asset (COGS, depreciation
expenses....) are remeasured using
prevailing rate at purchase

Revenue & other expense: average rate

Plug number: remeasuremen G/L is


recognized in Income statement

Net asset exposure:


Current rate method
Net liab exposure:

If foreign currency appreciate


Net monetary asset exposure:
Temporal method
Net nonmonetary liab exposure:

different translation G/L. IN, total


asset, income before translation
Compare 2 methods:

Multinational operation (part 1).mmap - 2/5/2017 - Mindjet


If parent curency depreciated,
current rate methods: ROA ;
Effect of Temporal ROE ;
translation vs Current
methods on rate TATO , invt TO , A/R TO
financial method
statement &
ratio of parent Pure BS or Pure IS ratio
Current rate vs original: Mixed BS/ IS ratio

USGAAP: 3-year accumulative inf


> 100% ( 26% per yr)
Hyperinflation IFRS: no definition

USGAAP: functional =
presentation, use temporal
methods

non-monetary asset & liab: adjust


Subsidiary operating in using price index btw acquisition
hyperinflationary economies date & balance sheet date

Shareholder equity: adjust using


Multinational price index from date of
operation Treatment
contribution or from year of
(part 2) IFRS beginning, whichever is later

Monetary asset & liab No adjustment

Net purchasing power G/L ->


income statement

Statutory tax rate


Impact on effective tax rate
Effective tax rate = tax expense / EBT

due to increase in volumes or prices


Organic growth more sustainable
Components of sales changes
and sustainability Growth due to
acquisition/divestitures

Growth due to currency effect

Find disclosures in MD&A, if any


Countries of operation affect
Conduct sensitivity analysis
financial results
Inquire about hedging tools

Multinational operation (part 2).mmap - 2/4/2017 - Mindjet


Reporting
quality Info is accurate & relevant

adequate > cost of capital


FR quality
Earning quality sustainable
a. Framework
for assessment accurate ( high reporting quality)

GAAP compliance?
Condition 1
Decision useful?
Conceptual
framework
Condition 2 high quality earning?

Measurement and timing issues


Arise from Classification issues

Channel stuffing

Revenue Bill & hold

Outright fake sales


Mechanism
Lessor use of finance lease

More operating revenue, more non


operating expense...

high revenue growth

A/R growth > sales growth


Misstate profitability
High customer returns

CFO < EBIT

Final quarter surprise


Warning signs
Inconsistency in operating
classification

Aggressive accounting
assumptions

Executive compensation tied to


financial results

Inappropriate model (useful life...)


Evaluating financial
reporting quality Reclassification from current to non-current
(part1) Biased
Mechanism Over/Understate allowance & reverses
accounting
Understate identifiable asset
(overstate GW)

Problems Inconsistency in model input for


affect FR Misstate assets/liab valuation of assets & liab
quality
Allowance & reverses differ from
peers & fluctuate

Warning signs High GW/total asset

Use of SPE

Large fluctuation in DTA, DTL

Large OBS liabs

Manage activities to affect CFO:


e.g.: stretching payables
Mechanism
Misclassify CFI as CFO

A/P increases while inventory &


Overstate CFO A/R decrease

Capitalized expenditures
Warning signs
Sales & leaseback of asset

Bank overdraft increases

Buy target with high CFO ->


increase CFO pay by stock or CFI

high accounting irregularities: buy


target with dissimilar operation or
with less publicly available
Business reason for acquiring may be information
combination
acquisition Both acquiring and target firms
method have incentives to pursue
aggressive accounting to inflate
stock price

overstate GW

GAAP accounting but not


economic reality

Evaluating financial reporting quality (Part 1).mmap - 2/5/2017 - Mindjet


Understanding company, industry,
accounting principles

Understand management
(compensation & independence)

Areas of accounting vulnerable to subjectivity


Evaluate
Compare cross-sectional & time
FR
series FS Ratios
quality 7 steps
Check for warning signs

Check for shifting of profits or rev.


among multiple business lines

Use quantitative tools to evaluate


the likelihood of misreporting

Estimate the probability of earning manipulation

DSRI =

GMI =
M-score = -4.84 + 0.92
AQI =
(DSRI)+0.528 (GMI)+0.404 (AQI)+
0.892 (SGI)+0.115 (DEPI)-0.172 SGI
(SGAI)+4.67 (Accruals)-0.327 (LEVI)
DEPI

Benish Model SGAI =

Accrual =

LEVI =

M-Score > -1.78-> higher prob of manipulation

Relies on accounting data


Evaluating financial Limitation company aware -> decreasing
reporting quality
Quantitative tool predictive power of model
(Part 2)

Assess the probability that a firm


will file for bankruptcy

NWC/total asset

RE/Total asset

Z-score using 5 variables EBIT/Total asset

Market value of equity/ book value of liab

Sales/total asset
Alman model
Higher Z-score -> lower
probability of bankruptcy -> good

a single-period static model -> not


capture the change in variables
over time
Limitation
relies on accounting data

high enough to cover capex, debt


repayment, div

Indicators CFO sustainable sources

low volatility

Checking unusual items or items


Cash flow quality
that have not shown up in prior
period

Revenue quality: aggressive


recognition -> increase A/R ->
Evaluation
reduce CFO

Strategic provision

Evaluating financial reporting quality (Part 2).mmap - 2/5/2017 - Mindjet


Company may include proforma
income -> check reconciliation
from proforma income to reported
income

to gauge earning persistance


Formula:
Formula:

Earning (t+1)=

Nondiscretionary occur as part of business

from non-normal transactions or


accounting choices
Earning quality
Accrual
sometimes used to manipulate earnings
Sustainable
earning total accrual as Y varibales
Discretionary
indicator : residuals from factor that give rise to normal
accrual as X variables

Red flag: Net income > 0 but CFO <0

Repeatedly meet or barely beat


consensus estimates

Enforcement actions by regulatory


Other indicators
authorities (SEC)
External indicators
Restatement

Extreme earning -> not


continue forever but revert back
Mean
to normal level
reversion in
earning
Evaluating financial Accrual increase -> mean
reporting quality (Part reversion faster
3)
Concern both quality & quantity

Understand the basics

Evaluate & question ageing A/R

Cash & accruals


Revenue recognition issues 6 steps
Compare financial vs physical data
Evaluate earning quality
Evaluate rev. trend and compare with peers

Check for related party transaction

Understand the basics

3 steps Trend and comparative analysis


Expense capitalization
Check for related party trx

Take-or-pay contracts -> should


record obligations
Check for OBS
Operating lease -> should capitalize
Completeness
concern when equity methods for
subsidiaries with close to 50%
ownership

Balance sheet quality


subjective in measuring pension,
investment, GW, Inventory, PP&E
impairment
Unbiased measurement

discretion in choosing to present


as a single-line item or grouped
Clear presentation clear presentation

Evaluating financial reporting quality (Part 3).mmap - 2/5/2017 - Mindjet


Framework for analysis Figure1

Are the sources of earning


sustainable over time?
1. Sources of earning & return on equity

Dupon analysis: ROE =

2. Asset base Common size BS

3. Capital structure

4. Capital allocation decision

Accrual =
Balance sheet approach
Accrual ratio =
Integration of FS analysis techniques
Accrual
Accrual =
Income statement approach
5. Earning quality & CF analysis Accrual ratio =

Lower -> better

Wide fluctuation -> high


Accrual ratio prob of earning
manipulation

6. Mkt value
decomposition

7. OBS financing

Eliminate operating lease


Predict the impact on financial
8.Anticipating changes in
statement and ratios of changes Eliminate QSPE
accounting standards
in accounting standards

Integration of FS analysis techniques.mmap - 2/5/2017 - Mindjet

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