Intercorporate InvestmentCategorization of intercorporate investments| Ownership proportion | Accounting treatment | Balance sheet | Income statement | Minority passive
< 20% | Held-to-maturity
(debt only) | At amortized cost Cost method | Int./div. at market rate | | Available-for-sale | at Fair Value
Unrealized Δ+/- as other comprehensive income in equity | Int./div. at par
Unrealized Δ+/- included at sale | | Held-for-trading | at Fair Value, market method | Int./div. at par + Unrealized Δ+/- | Minority active
20%-50% | Equity method
applicable for JV/GAAP | Original investment +
proportionate(net income - dividened) | Pro-rata share of earnings | Controlling
>50% | Consolidation | All assets, liabilities - minority interests account
(pro-rata share of subsidiary's net assets) | Net income * (1 - minority interest) | Joint venture
50:50 | Proportionate consolidation
(IFRS only) | Pro-rata share of assets +liabilities | Pro-rata shares of revenues + expenses | - Equity method investment in excess of book value (GAAP)
- Goodwill = purchase price - proportionate(net asset book value) - proportionate(FV-BVnon-current assets)
- Investment value = purchase price + proportionate(income - dividend) - amortization(proportionate(FV-BV))
- Transactions with associates
- [I/S]Equity income upon upstream purchase = %subsidiary reported income - excess purchase amortization - unrealized profit[=proportionate(sales price), similar treatment as shares repurchase]
- [B/S]Investment = purchase price + equity income upon sale - dividend
- Unrealized profit upon downstream sale = proportionate(%unsold(profit on sale))
- Purchase method: Assets and liabilities of target are recorded at fair value. Excess of purchase price over the fair value of identifiable net assets is recorded as goodwill. Goodwill is not amortized, but is subject to an annual impairment test. Prior results are not restated.
- Assets after the merger are reported higher on the balance sheet
- Incremental increase in depreciation subsequent to the merger
- Equity after the acquisition is higher; book value of equity in the acquired company is replaced by the purchase price
- Pooling method: Firms are combined using book values and the prior results are restated. No goodwill is created. Pooling generally results in more favorable results than purchase. Net income, net profit margin, ROA, and ROE are usually higher under pooling.
- more favorable performance measures. Higher profit margin, RoA, RoE
Variable Interest Entity: a legal structure created to isolate certain assets and liabilities from the sponsor - Primary beneficiary must consolidate a variable interest entity (special purpose entity) if it absorbs the majority of the risks or receives the majority of the rewards.
- the sponsor can avoid consolidating asset securitizations by creating a qualifying special purpose entity (US GAAP only)
- Rationale for Creation: lowers the cost of capital since the assets of the VIE are protected in the event the sponsor experiences financial difficulties.
- Business Form: can take the form of a corporation, partnership, joint venture, or trust, although the entity does not necessarily have separate management or even employees.
- Characteristics: financed primarily with debt, with a small equity component. The equity investors have limited risk and, thus, usually receive a small fixed rate of return. The variable interest (typically the sponsor) will absorb portions of the VIE’s potential losses and receive portions of the potential residual returns. The potential losses and residual returns can include the variability of net income and the variability of an asset’s fair value.
- Conditions for VIE if any
- Insufficient at-risk equity investment.
- Shareholders lack decision-making rights.
- Shareholders do not absorb losses.
- Shareholders do not receive residual benefits.
Employee Compensation- Defined-contribution plan: the firm contributes a certain sum each period to the employee’s retirement account. no promise regarding the future value of the plan assets; thus, the employee assumes all of the investment risk. Accounting is straight-forward; pension expense is equal to the firm’s contribution.
- Defined-benefit plan: the firm promises to make periodic payments to the employee after retirement. benefit usually based on the employee’s years of service and the employee’s salary at retirement. Since the employee’s future benefit is defined, the employer assumes the investment risk. Accounting is complicated because many assumptions are involved.
- Projected benefit obligation (PBO): actuarial present value (at the assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases
- Accumulated benefit obligation (ABO): actuarial present value of all future pension benefits earned to date based on current salary levels, ignoring future salary increases; used to determine whether a minimum liability allowance must be reported
- Vested benefit obligation (VBO): amount of the ABO to which the employees are entitled based on the company’s vesting schedule.Most companies require that employees work for the company for a specified period of time before they are entitled to full pension benefits.
Reported pension expense is a smoothed number consisting of: - Current service cost—the present value of benefits earned by the employees during the current period.
- Interest cost—the increase in the PBO due to the passage of time.
- Expected return on plan assets—reduces pension expense.
- Amortization of deferred gains and losses—allocation based on changes in actuarial assumptions and differences in the expected return and actual return on plan assets.
- Amortization of past (prior) service cost—allocation of a plan amendment that provided retroactive benefits.
- PBOf = service + interest + actual gain/loss - benefits paid (retirement compensation) + PBOI
- Firms can improve reported results by increasing the discount rate, lowering the compensation growth rate, or increasing the expected return on plan assets.
- Disclosure of a reconciliation of both the PBO and the plan assets required. In addition, IFRS requires reconciliation of the funded status and the net pension asset/liability
- Net pension expense = current service cost + interest - expected RoPA ± amortization(gain/loss + past service cost)
- firm’s contributions > economic pension expense => difference = reduction in the overall pension obligation
- firm’s contributions < economic pension expense => difference = source of borrowing.
- If the differences in cash flow and economic pension expense are material, consider reclassifying the difference from operating activities to financing activities in the cash flow statement.
- FairValuef = employer contribution + actual RoPA - benefits paid
Net asset/liability = funded status = Plan assets - PBO (U.S. GAAP) economic reality of the plan. - = funded status after eliminating the unrecognized past service cost, unrecognized deferred gains/losses (IFRS)
- CTAf = Asset - Liabilities - commonEquity - REf
- REf(final retained earning) = REi + NI - Div
Economic pension expense = sum of changes in PBO for the period - actual RoA = change in the funded status - firm’s contributions. - Operating expense <= service cost
- Nonoperating items <= interest cost, actual RoA
Share-based compensation plans: align the employees’ and shareholders’ interests and usually require no cash outflow from the firm’s perspective. - employee may have limited influence over the firm’s market value
- risk averse employees
- dilutes existing shareholders’ interests.
- based on the fair value at the grant date
- Types include stock grants, stock options, stock appreciation rights, and phantom stock.
Multinational Operations- Local currency: currency of the country to which it refers.
- Functional currency: determined by management, currency of the primary economic environment in which the entity operates.
- Presentation (reporting) currency: for financial statements.
- Foreign currency denominated transactions, including sales, are measured in the presentation currency at the spot rate on the transaction date. If the exchange rate changes, gain or loss is recognized on the settlement date.
- If the balance sheet date occurs before the transaction is settled, gain or loss is based on the exchange rate on the balance sheet date. Once the transaction is settled, additional gain or loss is recognized if the exchange rate changes after the balance sheet date.
| Temporal method | All-current method | | Functional currency | parent's presentation currency | local currency | | Subsidiary position | well integrated with the parent | relatively independent of the parent | | Assets/Liabilities | monetary A/L - current rate
nonmonetary A/L - historical rate | all current rate | | Common stock | historical | | Equity | mixed rate | current rate | | Revenues/SG&A | average rate | | COGS & Depreciation | historical rate | average rate | | FX Gain/Loss | historical rate | current rate in equity CTA account |
Exposure - net asset position (assets - liabilities) under all-current method
- net monetary asset/liability position under temporal method
- depreciating foreign currency -> assets=>loss, liabilities=>gain
Pure balance sheet and income statement- the local currency trends, relationships and ratios are preserved under the all-current method - Comparison of the ratio effects
- Determine whether the local currency is appreciating or depreciating.
- Determine which rate (historical rate, average rate, or current rate) is used to convert the numerator under both methods and analyze the effects on the ratio.
- Determine which rate (historical rate, average rate, or current rate) is used to convert the denominator under both methods and analyze the effects on the ratio.
- Determine whether the ratio will increase, decrease, or stay the same based on the direction of change in the numerator and the denominator.
Hyperinflationary environment cumulative inflation exceeds 100% over a 3-year period (more than 26% annual inflation)
- temporal method required under US GAAP
- restated for inflation, then translated using all-current method under IFRS
Financial Statements AnalysisCommon earnings measures - EBITDA- often used as a proxy for operating cash flow; does not consider the changes in operating accounts on the balance sheet
- EBIT- often referred to as operating earnings, or operating profit; excludes the effects of financing and taxes.
Income from continuing operations: This subtotal is equal to the firm’s earnings before any “below the line” items are considered. - Net income: the bottom line of the income statement
- Pro-forma earnings: In pro-forma disclosures, some firms have created their own measures of income, whereby they strip away certain nonoperating and nonrecurring transactions
- Operating cash flow is generally more reliable than earnings because it is less subject to estimates and judgments.
- There should be a fairly stable relationship between the growth of operating cash flow and earnings. If not, the firm may be engaging in earnings manipulation. Earnings growth is not sustainable without the support of operating cash flow over the long-run.ex. wide differences in operating cash flow and operating income in the case of Enron
Accounting treatment for derivatives | Purpose | Recognition |
|---|
| Fair value hedge | Offset exposure to changes in fair value of an asset or liability | Gains and losses are recognized in the income statement | | Cash flow hedge | Offset exposure to variable cash flows from anticipated transactions | Gains and losses are reported in equity. The gains and losses are eventually recognized in the income statement once the anticipated transaction affects earnings | | Net investment hedge of a foreign subsidiary | Offset exposure from an existing investment in a foreign subsidiary | Gains and losses are recognized in equity along with translation gains and losses | - Cash basis of accounting revenues are recognized when cash is collected; expenses are recognized when cash is paid
- enhanced predictive ability
- Accrual basis of accounting revenues are recognized when earned; expenses are recognized when incurred, regardless of the timing of cash flow; provides more timely and relevant information to users
- discretion necessary because many estimates and subjective judgments are involved
- can be "strategically" manipulated by management to achieve a desired result.
Accrual component - weight should be lowered in order to enhance persistency and provide reliable estimate
Incentive for exceeding markets expectation - more firms report small profits as compared to firms that report small losses
- more firms report earnings that slightly exceed sell-side forecasts as compared to firms that just miss the forecasts
- atisfying contractual provisions: numerous contracts rely on accounting data
Mechanisms designed to prevent manipulation: - An independent audit.
- The board of directors.
- Certification by senior management.
- Class action litigation.
- Regulators.
- General market scrutiny.
Earnings quality measurement for persistence and sustainability of a firm's earnings - Balance sheet based accrual ratio = (NOAend - NOAbeg) / NOAavg
- Cash flow based accrual ratio = (NI - CFO - CFI) / NOAavg
Mean reversion: earnings at extreme levels tend to revert back to normal levels over time - extreme earnings should not be expected to continue indefinitely
- when earnings are largely comprised of accruals, mean reversion will occur even faster
Manipulation and correspondent detection techniques - Revenue recognition—misstatement, revenue acceleration, misclassification of nonrecurring or nonoperating revenue.
- Look for large changes in receivables and unearned revenue.
- Look for increasing DSO.
- Compare revenue to actual cash collected.
- Expense recognition—understatement, expense delay, misclassification of ordinary expenses as nonrecurring or nonoperating.
- Look for large changes in fixed assets and inventory.
- Look for increasing DOH.
- Look for LIFO liquidation.
- Compare depreciation expense (relative to gross plant and equipment) to other companies to determine the conservatism of the firm’s estimates.
- Calculate core operating margin = (sales – COGS – SG&A) / sales.
- Balance sheet manipulation—off-balance sheet financing and goodwill.
- Capitalize operating leases.
- Look for lack of goodwill impairment.
- Cash flow statement manipulation—misclassification, ignorance, and managing cash flows.
- Compare the growth of operating leases with the firm’s asset growth.
- Be alert for a decrease in discretionary spending, especially near year-end.
Problems encountered in balance sheet analysis - some assets and liabilities are not recorded
- the book values of assets and liabilities may differ significantly from their market values.
Adjustment in need - Variable interest entity: for unconsolidated SPEs, effectively increase primary beneficiary's reported leverage by increasing assets/liabilities of primary beneficiary by the amount held in SPE
- Leases: To adjust the balance sheet for operating leases (i.e., capitalize them), increase the assets and liabilities by the present value of the lease payments. This results in higher leverage and lower asset turnover. lower of the firm’s financing rate or the interest rate that is implicit in the lease is to be used as the interest rate
- Guarantees, commitments, and contingencies: adding the present value of the transaction to both assets and liabilities if sufficient information is available in the footnotes.
Typical balance sheet adjustments to reflect market values of assets include: - Converting LIFO inventories to FIFO.
- Adjusting accounts receivable to reflect customers' credit risk.
- Adjusting accounts receivable for the sale of receivables with recourse.
- Marking-to-market non-financial assets such as real estate.
- Revaluation of operating assets (this can be difficult).
- Estimate of pension plan value over projected benefit obligation.
- Revaluation (or total elimination) of intangible assets.
- Adjusting inventories or plant, property, and equipment held in foreign countries to reflect currency effects.
Typical balance sheet adjustments to reflect market values of liabilities include: - Restatement of deferred income taxes to reflect the probability of reversal and present value (could affect assets as well).
- Revaluation of long-term debt to reflect current interest rates and risk.
- Revaluation of preferred stock to reflect current market value (preferred stock may be included as part of stockholders' equity).
Normalization: ferret out the noise inherent in net income and restate income in terms of earning power - Normal operating income: income of the firm without all the noise that is included in most income statements, reflects the earning power
- Comprehensive income: an income measure that aggregates all the valuation changes to assets and liabilities in a component of the equity account; allowing for all changes in equity
U.S. GAAP dictates that the following direct-to-equity adjustments be included: - Funded pension status in accordance with SFAS 158.
- Unrealized gains and losses on available-for-sale securities according to SFAS 115.
- Cumulative foreign currency translation adjustments related to SFAS 52.
| Balance sheet adjustment | | Items | Adjustment in need | Assets | Liabilities | Equity | | Unconsolidated SPEs | equity accounting to proportional/full consolidation | ↑ | ↑ | = | | Operating leases | Capitalization | ↑ | ↑ | = | | Guarantees | | ↑ | ↑ | = | | Contingent liabilities | | = | ↑ | R/E ↓ | | Marketable securities | cost to market value(↑) | ↑ | = | ↑ | | Revenue recognition method | % completion to completed contract | (either ↓ | or ↑) | ↓ | | Bad debt provision | prudence ↑ | ↓ | = | R/E ↓ | | Sale of receivables | | ↑ | ↑ | Δ | | Inventory capitalization policy | use lower of cost and market value | ↓ | = | R/E ↓ | | Inventory valuation method | LIFO -> FIFO (rising prices) | ↑ | = | R/E ↑ | | Inventory foreign currency effects | historic->current rate
(temporal method, current > historic) | Inventory ↑ | = | R/E↑ | | PP&E capitalization | expense improperly capitalized items | ↓ | = | R/E ↓ | | Capitalization of interest | expense capitalized interest | ↓ | = | R/E ↓ | | Depreciation method and UEL | straight line to accelerated, UEL ↓ | ↓ | = | R/E ↓ | | Foreign currency effect | historic->current rate
(temporal method, current > historic) | ↑ | = | R/E ↑ | | Computer software | | ↓ | = | R/E ↓ | | PP&E/intangible asset inflation effects | revalue to market value
(assuming market value ↑) | ↑ | = | comprehensive
income ↑ | | PP&E and intangible impairment | | ↓ | = | R/E ↓ | | Goodwill write-off | | ↓ | = | ↓ | | Research and development | bring on if economic value present | ↑ | = | R/E ↑ | | Long-term investments | associates equity to proportional | ↑ | ↑ | = | | Long-term debt | amortize cost to market value
(assuming market value ↑) | = | ↑ | ↓ | | Deferred revenue | review revenue recognition | = | ↑ | R/E ↓ | | Convertible debt | reclassify to equity if conversion is likely | = | ↓ | ↑ | | Redeemable preferred stock | reclassify as debt | = | ↑ | ↓ | | Pension asset/liability | adjust to reflect economic status
(SFAS 87) | (either Δ | Δ) | Δ | | Employee benefit stock option plans | account for time value
(pre SFAS 123R) | = | = | common stock APIC ↑
R/E ↓ | | Deferred tax asset/liability | record at present value
(assuming deferred tax liability) | = | ↓ | R/E ↑ | | Deferred tax liability | eliminate liability - probability of reversal | = | ↓ | R/E ↑ | | Deferred tax asset | increase valuation a/c
if future taxable income is insufficient | ↓ | = | R/E ↓ | | Additional IAS adjustments | consider impact of revalued fixed assets on comparability
consider the impact of capitalized development costs |
Income statement adjustment - Remove non-operating items
- Measure earnings power
- Normalize operating earnings
- Remove cyclicality impact
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