INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

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1 Study Session # 5, Reading # 21 INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS 1 = International Financial Reporting Standards = United States Generally Accepted Accounting Principles. GAFS = Goods Available for Sale. C.A = Current Assets. W.C = Working Capital. CFO = Cash Flow from Operations. FIFO = First-in-First-Out LIFO = Last-in-First-Out B.S = Balance Sheet I.S = Income Statement. 1. INTRODUCTION Choice of inventory valuation method different amounts to inventory & cost of sales. specific identification, FIFO, weighted Avg. cost method. same three as above and also a fourth method LIFO. F.S = Financial Statements. I.T = Income Tax. EBIT = Earnings before Interest & Tax NRV = Net Realizable Value W-I-P = Work-in-Progress C.V = Carrying Value COGS = Cost of Goods Sold T.A = Total Assets N.I = Net Income. EBT = Earnings before Tax G.P = Gross Profit 2. INVENTORY AND CHANGING PRICE LEVELS Term for Inventory Valuation Methods Choice of cost formula Cost flow assumption Specific Identification Items are not interchangeable. Cost flow match actual physical flow. Inventory Actual cost unsold items Cost of Sale Actual cost sold items FIFO Items purchased or manuf. first, sold first. Inventory (B.S) Cost of sale (I.S.) Most recent purchases reflect current cost. Prices cost C.A W.C T.A & vice versa. Older costs. Prices costs G.P EBIT EBT N.I tax CFO & vice versa. Weighted Avg. Cost Total cost/total units Inventory (B.S) Cost of sale (I.S) Avg. Cost Avg. Cost Inventory Systems Periodic Inventory System Perpetual Inventory System Inventory value & cost of sale determined at period end Inventory value & cost of sale continuously updated If inventory method is identification or FIFO allocation of GAFS to inventory & cost of sale is similar. Periodic inventory system allocation is quite different under FIFO & weighted avg. Perpetual inventory system allocation is similar under FIFO & weighted avg. Perpetual system dominates no adjustment by analyst.

2 Study Session # 5, Reading # 21 2 LIFO Most recent items sold first Inventory (B/S) Cost of sale (I.S) Oldest items. Price cost C.A W.C T.A & vice versa. Reflect current cost. Price cost G.P EBIT EBT N.I tax CFO & vice versa. Under LIFO periodic & perpetual system results in different allocation. Choice of valuation method irrelevant if costs remain constant & direct impact on F.S. 3. THE LIFO METHOD LIFO conformity rule LIFO method for both tax & reporting purpose. If prices current ratio debt to equity ratios profitability ratios. If prices LIFO is not suitable for tax purpose COGS N.I taxes. Proposed adoption of elimination of LIFO method immediate I.T liabilities in year of transition. 3.1 LIFO Reserve Companies using LIFO method requires disclosure about LIFO reserve. LIFO reserve = FIFO inventory LIFO inventory. Adjustments for Comparison Inventory Cost of Sale Inventory LIFO + LIFO reserve = inventory FIFO COGS LIFO - LIFO reserve = COGS FIFO 3.2 LIFO Liquidations LIFO reserve due to of costs to value inventory under LIFO & FIFO method. No. of units purchase > no of units sold. Check LIFO reserve footnote disclosure reserve indicate LIFO liquidation. Units sold> units purchased = LIFO liquidation. G.P due to lower COGS one time event not sustainable. Variety of reasons (labor strikes, recession) outside control or potential manipulation by management. 4. INVENTORY METHOD CHANGES Valuation Method Changes Allow, if is justifiable. Applied retrospectively. Cumulative amount, periods prior to current F.S. Exemptions to restatement if effects are impracticable to determine. U. S.GAAP In accounting & inventory policy are similar to. LIFO to other method retrospective. Other method to LIFO prospective basis. Analyst should evaluate the real purpose of changes (e.g. reduce I.T, profits).

3 Study Session # 5, Reading # 21 3 ` 5. INVENTORY ADJUSTMENTS Significant financial risk from holding of inventory. Inventory Measurement Lower of cost or NRV. NRV = sale price cost necessary to make sale. If inventory value < C.V loss in I.S (COGS). Reversal is allowed up to original write-down. Lower of cost or MV. Market = replacement cost (upper & lower limits). Upper limit = NRV. Lower limit = NRV normal profit. Reversal of write down not allowed. Write-down, profit & inventory, profitability liquidity & solvency ratios, activity ratios. Write-down has significant impact on ratios, analyst must be careful. Write-down less likely under LIFO method (oldest & lowest costs). Agri, forest minerals products at NRV both &. ` 6. FINANCIAL STATEMENT ANALYSIS ISSUES Disclosure about suitable inventory classification (both standards). Raw material or W.I. P may signal, demand, sales & profits. Finished goods, raw material & W.I.P, demand, sales & profits. Compare sales growth rate with finished goods growth rate. Too much or wrong type inventory less cash & W.C

4 Study Session # 5, Reading # 22 LONG-LIVED ASSETS: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS 1 R&D = Research & Development SGA = Selling, General & Admin G.P = Gross Profit C.V = Carrying Value F.V = Fair Value R.V = Recoverable Value H.C = Historical Cost P&L = Profit & Loss OCI = Other Comprehensive Income T.A = Total Assets ROA = Return on Assets A&L = Assets & Liabilities 1. INTRODUCTION Long Lived Assets Tangible Identifiable intangible PP&E (e.g.) G/W, patents (e.g.) Accounting choices related to long lived assets affect timing of expense recognition. PP&E = Property, Plant & Equipment G/W = Goodwill F.S = Financial Statements. I.S = Income Statement B.S = Balance Sheet C.F = Cash Flow N.I = Net Income R.E = Retained Earnings CFO = Cash Flow from Operations COGS = Cost of Goods Sold CFF = Cash Flow from Financing ROE = Return on Equity 2. CAPITALIZING VERSUS EXPENSING Asset value= acquisition cost + cost to get the asset ready to use. Cost of a tangible item recognized as an asset if (, same guidance under ). Probable that future benefits will flow to entity. Cost measured reliably. Intangible assets (, similar guidance under ). Identifiable. Under the control of entity. F.S. impact of Cap. V/S Exp. Generator of future economic benefits. Capitalized Expensed I.S B.S C.F I.S B.S C.F Dep & Amor. Assets. Investing CF. N.I by after tax amount of expenditure. No assets. Operating C.F. Capitalizing profits (1 st year), profitability ratios in subsequent years & vice versa in expensing. Capitalizing equity (early years) due to R.E. Profitability-enhancing effect of capitalizing continues if expenditures continue to be more than dep. exp. Capitalizing results CFO (important consideration in some valuation models). If identical methods for reporting & taxes, expensing have favorable tax impact in earlier period. (Lower taxes). 2.1 Capitalization of Interest Costs Must capitalize interest cost when constructing a longer time requiring asset. Interest rate May based on existing borrowings. Loan specifically to construct building. Interest cost may appear in B.S (capitalized) or I.S. (expensed). Interest Expenditure Constructing own use asset Asset to sell Analyst should consider. Investing cash outflow as operating outflow. Total interest (capitalized & expensed) in interest coverage ratio. Depreciating interest adjusted to eliminate effect of depreciation. B.S as part of relevant asset. Become part of depreciation. B.S as part of inventory. Expensed as part of COGS.

5 Study Session # 5, Reading # Capitalization of Internal Development Costs Cost of internally develop intangible assets are generally expensed exceptions as under. Research & Development Exp. on research Exp. on development Expensed (certain exception as under) Expensed Capitalized Software development For sale expensed until feasibility, then capitalized. Judgment determining feasibility. Internal use capitalized. Similar F.S. impact of R&D expensing V/S capitalizing as other type of expenditures. Company that capitalizes software development cost, analyst can adjust. Analyst Adjustment I.S B.S C.F Include cost. Exclude prior year s amortization. assets & equity. Operating C.F. Cash used in investing current period dev.cost. 3. DEPRECIATION Long-lived tangible & intangible assets with finite useful lives are subject to dep & amortization. 3.1 Depreciation Methods Method chosen must reflect patterns of future economic benefits consumed. Dep. Methods Accelerated Dep. method Straight-line methods Units-of- production method Dep income (earlier years) & vice versa Even dep. exp Variable dep. exp 3.2 Estimates Require for Depreciation Calculations Estimates Useful Life Expected Residual Value Longer life dep. exp Residual value Dep exp in estimates is made prospectively. Additional estimates to allocate dep. exp. b/w COGS & SGA. Apportionment of dep explains diff. in G.P margin & operating expenses.

6 Study Session # 5, Reading # IMPAIRMENT AND REVALUATION OF LONG-LIVED ASSETS Impairment unanticipated decline in value of asset. Write down the carrying amount of impaired assets (both standards). Impairment reversal allowed Revaluation model for valuing assets. Reversal not allowed Model not allowed. 4.1 Impairment of Long-lived Tangible Assets Held for Use Impairment loss C.V > F.V & not recoverable. Impairment Excess of C.V > R.V Recoverability assessed. R.V = > of, F.V cost & value in use Not recoverable if CV > undiscounted future C.F. Value in use = discounted value of future C.F. If impaired, loss = diff. b/w F.V & C.V. Impairment loss, assets, net income, no effect on C.F. Impairment used to manage earnings. G/W & identifiable intangible assets tested annually or more frequently. Guidelines for Impairment Test Annually Events & circumstances indicate 4.2 Revaluation of Long-lived Assets Historical cost model (), revaluation model or H.C model (). Model of Accounting for long-lived assets Historical Cost Revaluation Fair value Revaluation frequecnydepends on periodic changes H.C Acc. Dep, adjusted for impairment Market based discounted C.F or replacement if market value not available. allow revaluation model for some assets classes & cost model for other classes. Revaluation affects on earnings Assets C.V Assets C.V In P&L. If value later on reversal allowed up to previous decline. In OCI (revaluation surplus). Subsequent decline, 1 st decline OCI then in I.S. Asset retired or disposed of related OCI transfer to retained earnings C.V, T.A, equity Leverage dep. C.V, N.I, ROA, ROE (year of revaluation), profitable in future years. Analyst should consider who did appraisal (independent or management).

7 Study Session # 5, Reading # FINANCIAL STATEMENT DISCLOSURES: ANALYSIS AND DISCLOSURE Disclosure about usage of assets, avg. age of assets & avg. remaining useful life. Disclosures about Long-lived assets (PPE) Balance Sheet Income Statement Statement of C.F At HC-Acc dep & impairment Acquisitions & disposals of fixed assets in investing section May or may not separate line item Nature of expense method Function of expense method According to nature (e.g. dep, purchase of material) According to function part of COGS or SG& A Old assets & shorter life need to reinvest. Relationships for Assets Estimated Total Useful Life Historical Cost Estimated Age Estimated Remaining life Estimated age + remaining life or historicalcost/ dep. exp Acc.Dep. + Net PPE Acc.Dep/Annual Dep. Net PPE /Annual Dep. 6. LEASING Contract b/w lessor (owner) & lessee (user) of an asset. 6.1 The Lease versus Buy Decision Leases have several advantages Less costly financing. Less restrictive provisions. Reduce risk of obsolescence, residual value etc. Financial & tax reporting advantages. Some leases are off-b.s. Lease with tax benefits (Dep), without reflecting asset in B.S is synthetic lease. 6.2 finance versus Operating Leases Types of Lease Finance Lease Operating Lease Equivalent to purchase Agreement to use asset (essentially rental) All risks & rewards transferred to lessee (). Risks & rewards bear by lessor. Asset & liabilities in B.S. Similar risk reward guidance plus any one of four specific requirements.

8 Study Session # 5, Reading # Accounting & Reporting by the Lessee Lease Treatment Finance Lease Operating Lease B.S Lease asset. Lease payable (liab). Lower of F.V or PV of future payments. I.S Interest exp (debt). Dep exp (asset). Lease exp (I.S). No A&L (B.S). Debt, assets & expense (early years), ROA under finance lease. Lessee prefers operating lease & lessor prefer finance lease. Lease payment operating C.F (operating lease). Interest exp operating C.F, portion that reduces liab. C.F.F. Operating lease profits, return (early years) & stronger solvency. Year by year (1 st five year). Aggregated for subsequent years. Lease Disclosure Disclosed for 1 st year. Aggregate 2-5 year Aggregate for all subsequent years Accounting & Reporting by the Lessor Same four criteria as lessee plus revenue recognition criteria for lease type. Lease Treatment Operating Lease Finance Lease Lease revenue & Dep (I.S). Asset (B.S). Interest revenue (I.S). Record Lease receivable & reduce assets. Two Types of Finance Lease, Lessor s perspective (). Direct Finance Lease Sales Type Lease Lease receivable = carrying amount of leased assets. Lease receivable > carrying value. Profit in 1 st year. No profit only interest revenue. Interest revenue over life.

9 Study Session # 6, Reading # 23 1 INTERCORPORATE INVESTMENTS HFT = Held-for-Trading HTM = Held-to-Maturity AFS =Available-for-Sale I.S= Income Statement C.A = Contingent Assets C.L = Contingent Liabilities N.I = Net Income B.C = Business Combinations B.V = Book Value JCE = Jointly Controlled Entities G/L: Gain & Loss B.S: Balance Sheet FV: Fair Value R.E = Retained Earnings R&D = Research & Development F.G = Financial Guarantee D&E = Debt & Equity JCO = jointly Controlled Operations JCA = jointly Controlled Assets 1. INTRODUCTION CF = Cash Flow CV = Carrying Value G/W = Goodwill DFV = Designated at Fair Value P.P = Purchase Price P or L = Profit or Loss CFO = Cash Flow from Operations QSPE = Qualifying Special Purpose Entity PV = Present Value HC = Historical Cost VIE = Variable Interest Entity T.C = Transaction Cost A&L = Asset & Liability R&E = Revenue & Expense SPE = Special Purpose Entity T.A =Total Assets T.L = Total Liabilities MV: Market Value 2. BASIC CORPORATE INVESMENT CATEGORIES Financial assets No significant control (ownership < 20%). Investment in associates Significant influence over investee s operations (ownership 20%-50%). Business combinations Control over investee s operations (ownership > 50%). Joint venture Shared control. Ownership %age is only a guideline; ultimate category is based on investor s ability to influence. 3. INVESTMENTS IN FINANCIAL ASSETS (Passive Invt.) HTM,AFS,FV Through P or L. HTM,AFS,HFT,DFV. 3.1 Held-to-Maturity 3.5 Reclassification of Investments Debt Securities Long term initially FV+TC(). cost +TC(). Balance Sheet Amortized cost (original cost ± Discount/premium). 3.2 Held-for-Trading Income Statement Interest income. Can t be reclassified into & out of DFV & out of HFT. not permitted to classify HTM if company sold significant HTM investment during current or two preceding years (certain exceptions). AFS debt to HTM, with FV at B.S & difference b/w fair & maturity value & G/L in other comprehensive income amortized over security life. U.S. GAAP From AFS HFT = cumulative or unrealized G/L in I.S D&E Securities Short term. Balance Sheet Fair value. No TC in FV in any yr. Income Statement Realized & Unrealized G/L. HTM to AFS, with FV at B/S & difference b/w fair & CV is in other comprehensive income. Debt security of AFS into HTM cumulative G/L amortize over security life. HTM to AFS = unrealized G/L to comprehensive income. 3.3 Available-for-Sale 3.6 Impairments D&E Securities Neither HTM nor HFT. Initial (FV+TC). Later (FV only). D&E Securities HTM or AFS. Balance Sheet Fair value, unrealized G/L in equity. 3.4 Designated at Fair Value Balance Sheet Fair value. Income Statement Realized G/L. Foreign currency unrealized G/L(Debt Sec ). Income Statement Realized & Unrealized G/L. Evaluate HTM & AFS securities for impairment. Debt security is impaired if one loss event occurred, equity security is impaired if FV < CV. HTM security impaired, B/S value is PV of future C.F, loss in I.S & reversal is allowed. AFS security impaired, unrealized loss in I.S. equity can t be reversed. U.S. GAAP Evaluate HTM & AFS securities for impairment. Security is impaired if decline is not temporary. AFS Subsequent increase reported in OCI.

10 Study Session # 6, Reading # INVESTMENTS IN ASSOCIATES 6. BUSINESS COMBINATIONS 4.1 Equity Method of Accounting: Basic Principles Initial investment At cost as noncurrent asset. 4.2 Investment Costs That Exceed the Book Value of the Investee Excess of purchase price over book value is allocated to FV of A&L, any remainder is G/W. FV or HC (less Acc.Dep) HC only (less Acc.Dep) 4.3 Amortization of Excess Purchase Price Investor recognizes expense based on excess amounts & consistent with investee s expense recognitions. 4.4 Fair Value Option Investment A/c at FV through irrevocable election. U.S. GAAP all entities, restricted. No prop. Share in B/S. No goodwill, G/L, Div.in B/S. 4.5 Impairment FV < CV investment is impaired, B/S fair value, loss I.S, reversal not allowed. 4.6 Transactions with Associates Profit from upstream (investee to investor) or downstream must be deferred until confirmed thought use or sale to a third party. 4.7 Disclosure About A&L & results of equity method. Higher earnings Dividend payout is < 100%. Investee s earnings Increase investment A/C, non operating income & vice versa in case of loss. 4.8 Issues for Analysts Ratios impact Improves certain ratios. Dividends received Decrease investment A/c. C.F. problem Earnings may not in form of C.F. No distinction among B.C Merger A+B=A Acquisition A+B=A+B Consolidation A+B=C 6.1 Pooling of Interests Term Pooling of interests Uniting of interests Assets & liabilities at B.V, pre comb. R.E included. No new accounting basis & continuity of ownership. Purchase method: Net FV, Add.Dep, lower reported earnings. 6.2 Acquisition Method Both & U.S. GAAP require the acquisition Method Recognition and Measurement of Identifiable Assets and Liabilities Identifiable assets & liabilities at F.V. Acquirers recognize A&L not previously recognize by acquiree (e.g brand name) Recognition and Measurement of Contingent Liabilities Acquirer recognize contingent liability if Present obligation arise from past events Measured reliably Fair value can be reliably measured. Probable & reasonably estimated Recognition and Measurement of Indemnification of Assets Acquirer recognize assets If acquiree indemnifies Recognition and Measurement of Financial Assets and Liabilities Acquirer can reclassify financial A&L of acquiree on basis of certain conditions Recognition and Measurement of Goodwill Partial G/W (PP-Acquirer s share of FV). Full G/W (FV of acquisition-fv of ident.net assets). Full G/W Recognition and Measurement When Acquisition Price Is Less than Fair Value Contingent consideration at FV & subsequent changes in I.S. Difference b/w PP & F.V of acquired net assets immediately in I.S. Diff. as pro rata reduction in F.V of acquired assets (prior to 15 Dec 08) after 15 Dec. treatment is same as. 5. JOINT VENTURES Shared control Two or more investors. Preferred method No minority interest Proportionate share of A&L, R&E. Items. Prpor.C Equity N.I TA,TL, sale, exp. Same High Same Low. Proportionate consolidation. Equity method allowed. (onlyj.c.e) Equity method required except limited situations.(unincorporated entities). J.C.O J.C.A J.C.E

11 Study Session # 6, Reading # Impact of the Acquisition Method on Financial Statements, Post-Acquisition Financial statements continue to be affected. 6.4 Consolidated Financial Statements Combine the results of operations. Control component Control Model Variable interest component. Voting interest component The Consolidation Process Combines A&L, R&E of subsidry with parent. Intercompany transactions are eliminated Business Combination with Less than 100 Percent Acquisition Merger or consolidation Acquire 100% equity. Acquisition < 100% (parent, subsidry relationship) Noncontrolling (Minority) Interests: Balance Sheet Subsidry s equity held by third parties. Separate component of equity (both & converged) Equity Full G.W method Partial G.W method Before convergence Liabilities or mezzanine Measurement Full G.W method Noncontrolling (Minority) Interests: Income Statement A line item reflecting allocation of P&L. Intercompany transactions are eliminated in full. Impact on ratios would be diff. under full G/W & partial G/W. Value of noncontrolling interest on parent s B/S will change Goodwill Impairment Impairment test annual or more frequent. Written down G/W. can t be later restored. Impairment loss is separate line item in I.S (both & ). Assignment Cashgenerating unit Impairment test (one step) Rec. amount < C.V= loss Loss reduced G/W & other assets when G/W = 0. G/W assignment & impairment Test Assignment Reporting unit Impairment test (2step) C.V> F.V= impairment occurred. C.V implied FV = amount of Loss. Loss reduced G/W but not other assets. 6.5 Financial Statement Presentation Subsequent to the Business Combination Presentation is similar under &. 6.6 Additional Issues in Business Combinations That Impair Comparability Contingent Assets and Liabilities Cost of acquisition allocated to F.V of A,L & contingent L. C.L at F.V ( Initially) > of amount recognized & amount req. to settle (subsequent) Contingent assets not recognized Contingent Consideration May negotiated as part of acquisition price. Initially measured at F.V either L or Equity (both &) Can also classify as asset (). Subsequent changes in I.S. Not remeasured equity classified.(both &) In-Process R&D A separate intangible asset at FV (both & GAAP). Subject to amortization or impairment Restructuring Costs Expense in the period the costs are incurred. Not a part of cost of acquisition (both standards). Contractual contingent A&L at FV at acquisition Non-contractual recognize only if meet the def. of A or L at acquisition. Subsequently C.L > of initial amount or estimate of loss. C.A < F.V or future settlement amount. 7. VARIABLE INTEREST AND SPECIAL PURPOSE ENTITIES To accommodate specific needs of the sponsor. Transfer A &L from sponsoring company s B.S. as sale. Improve certain ratios of sponsor by avoiding consolidation. Consolidate if controlled by reporting entity. Financial guarantee concept. F.G at F.V (initially) higher of settlement or initially recognized amount (subsequently). Certain indicators of control not clear guidance. More general term VIE as compare to SPE (). VIE includes other entities besides SPEs. Primary beneficiary must consolidate VIE if controls (certain indicators). Entity absorb losses must consolidate (if other entity will receive residual return). NCI in VIE also be shown in I.S & B.S. 7.1 Qualifying Special Purpose Entities Were used to avoid consolidation () currently not allowed under both standards. Transparency & comparability. To be QSPE an entity had to Be independent, complete control over assets. Hold only financial assets, bankruptcy remote (risk limited to investment or recourse obligation). Principles-based approach to return & loss distribution. 7.2 illustration of an SPE for a Leased Asset SPE borrow debt buy asset lease it to repay debt & return to equity holders. Sponsor bear default risk, asset ownership, so consolidate. 7.3 Securitization of Assets SPE issue debt to acquire sponsor s receivables. Repayment of debt & interest from C.F from receivables. Analyst should consider several issues (e.g. impact on CFO). 7.4 consolidated versus Nonconsolidated Securitization Transactions Common type of QSPE is securitization transaction.

12 Study Session # 6, Reading # 24 EMPLOYEE COMPENSATION: POST EMPLOYMENT & SHARE-BASED 1 B.S = Balance Sheet A&L = Asset & Liability FV = Fair Value DB =Defined Benefit PV = Present Value G/L = Gain & Loss FV = Future Value I.S = Income Statement C.F = Cash Flow SG = Salary Growth ROA = Return on Assets MP = Market Price D.R = Discount Rate PBO = Projected Benefit Obligation OPEB = Other Post Employment Benefits 1. INTRODUCATION 2. PENSIONS AND OTHER POST-EMPLOYMENT BENEFITS OCI = Other Comprehensive Income IR = Interest Rate EP =Exercise Price DY = Dividend Yield RF = Risk Free GBO = Gross Benefit Obligation B.P = Benefits Paid FN = Footnotes ER = Expected Return 2.1 Types of Post-Employment Benefit Plans and Implications for financial Reports Defined Contribution Plan Investment risk by employees. Future benefit is not defined. Pension expense = employer contributions. Defined Benefit Plan Investment risk by employer. Future obligation based on plan formula. Companies pre-fund the plans. Other Post Employment Benefits Similar to defined benefit except funding. Expense when benefits earned. Eventual benefits are specified. 2.2 Measuring a Defined Benefit Pension Plan s Liabilities Projected benefit obligation Defined benefit obligation (). PV of future benefit earned to date. Firm is a going concern. Consider salary growth. Accumulated benefit obligation PV of future benefit earned to date (vested or non-vested). Firm is not a going concern. Ignore salary growth. Vested benefit obligation Actuarial present value of vested benefits. 2.3 Measuring a Defined Benefit Pension Plan s Periodic Costs In pension obligation offset by earnings on plan assets. DB obligation DB obligation Service during period. Interest expense. Past service cost. Actuarial gains & losses. Curtailments. Settlements. 2.4 Financial Statement Reporting of Pension and Other Post-Employment Benefits Balance Sheet Defined contribution plan Defined benefit plan Unpaid contribution usually insignificant. U.S. GAAP Defined benefit liabilities (smoothed number) PV of benefit obligation. ± Actuarial G/L not recognized. - Past service cost not recognized. - FV of plan assets. If plan obligation < plan assets then company report pension asset. Funded status (benefit obligation- FV of plan assets). If plan obligation > plan assets then underfunded & vice versa. Prior to SFAS 158 similar treatment as still under.

13 Study Session # 6, Reading # Pension Expense Defined contribution plan Defined benefit plan Amount of annual contribution Service costs In obligation during period. Expense & fully recognized. Interest expense Based on opening pension obligation. Expense & fully recognized. Past service costs Vested expense immediately, unvested amortized. Portion not expensed, amortized (other comprehensive income). If cumulative amount of unrecognised actuarial G/L exceeds 10% of the greater of the value of plan assets or PV of DB obligation, difference amortized over employees service lives. Actuarial gains & losses Immediately in I.S or equity (OCI). Deferred & amortized using corridor or faster recognition method. Immediately in I.S. Deferred & amortized using corridor or faster recognition method. Return on plan assets Expected return decrease the expense. Difference b/w expected & actual return considered part of actuarial G/L Effect of Assumptions and Actuarial Gains and Losses on Pension and Other Post-Employment Benefits Expense Defined contribution plan Defined benefit plan Other post employment benefit P.exp= employer contribution No assumptions Many assumptions (e.g. employee turnover, length of services ) In assumptions cause pension oblg. Estimates about P. liab. & assets affect pension exp. Actuarial loss pension oblg. & vice versa. Require assumptions & estimates. Trends in health care near term costs life expectancy, earlier year in which trend rate reached obligation & exp. (Improve results). Discount Rate DR PV of P. oblg. P. exp. interest cost (except mature plan). (Improve results). Salary Growth SG PBO P. exp. (improve results). Expected Return ER P. exp, no effect on benefit oblg. or funded status. (Improve results). 2.5 Evaluating Disclosures of Pension and Other Post-Employment Benefits Pension accounting affects comparative financial analysis due to Diff. in key assumptions. Diff. in funded status determination (, ). Smoothing mechanisms. Exp. single line (), various lines (). C.F information not comparable. Net amount in B.S. Analyst adjusts A&L for gross amount. Actual return on plan assets as income. Interest on plan liability as expense. (). Analyst adjustment reflect eco L&A. Analyst should check size of gross B.O relative to firm s assets, equity & earnings Assumptions Disclose assumptions in F.N about DB & OPEB e.g. DR, expected return. DR is market IR of high quality bond. Diff. DR due to Diff. in region & timing of obligation. Consider assumptions are internally consistent Underlying Economic Liability (or Asset) Funded status is economic net funded position. Analyst look footnotes to find GBO & FV of assets for eco. net funded position.

14 Study Session # 6, Reading # Underlying Economic Expense (or Income) Sum of all in PBO (expect B.P) -actual ROA. Economic Exp. calculation in funded status firm s contributions. Calculated by removing smoothing amounts. Reported p.exp, differ from eco. exp because of smoothing certain component. Analyst adjusts these components for eco. Expenses. Reported P.exp treated as operating exp. Adjustments for better operating results Service costs Operating exp. Interest & actual ROA Non operating items Cash Flow Information If firm s contribution > eco. pension exp. then difference is reduction in pension obligation. If pension exp.> contribution then difference is source of borrowing. If difference is material, analyst reclassify the difference from operating to financing activities in C.F. 3. SHARE-BASED COMPENSATION Require no cash outlay. Both & require disclosure of management compensation. Align managers interest with shareholders. Recipient has no influence over MP. Ownership diluted (existing owners). Grant date Service period Vesting date Exercise date Several important dates Day options are granted Period B/W grant date & vesting date Date employee can first exercise options Actual options exercise date 3.1 Stock Grants 3.2 Stock Options 3.3 Other Issues Related to Share-Based Compensation Outright transfer Without condition. Restricted stock Can t sell until vesting. Performance stock Contingent on meeting performance. Accounting numbers manipulation e.g. earnings, ROA. Compensation expense FV at grant date allocated over service life. Intrinsic value method MP > EP (at grant date). Since most options are out of money at grant date, no compensation expense. Fair value method Based on observable MP of similar options. Option pricing model e.g. binomial (in absence of MP). Inputs are important some are known, others are subjective.(e.g. volatility). Volatility estimated life RF FV while D.Y FV. Compensation expense is allocated in I.S b/w grant date & vesting date at FV. Stock appreciation rights Pay in cash, equity or combination of both if price from specified level. Stock appreciation limits the risk aversion problem. Phantom stock Payoff depends on performance of hypothetical stock (private or illiquid).

15 Study Session # 6, Reading # 25 1 MULTINATIONAL OPERATIONS F.C = Foreign Currency A&L = Assets & Liabilities P.P.L = Purchasing Power Loss G/L = Gain & Loss I.S = Income Statements B.S = Balance Sheet A.R = Accounts Receivable A.P = Accounts Payable I/E = Income or Expense R/E = Retained earnings COGS = Cost of goods sold H.C = Historical cost F.V = Fair value C.V = Current value 1. INTRODUCTION Two types of F.C activities Transactions denominated in F.C. Invest in foreign subsidiaries. R&E = Revenue & Expense C.R = Current Rate H.R = Historical Rate P.P.G = Purchasing Power Gain FIFO = First-in-First-Out LIFO = Last-in-First-Out FASB = Financial Accounting Standard Board IASB = International Accounting Standard Board CTA = Cumulative Translation Adjustment 2. FOREIGN CURRENCY TRANSACTIONS Companies decide currency in international trade. F.C transactions are denominated in currency other than company s functional currency. Different types of currencies Presentation currency Functional currency Local currency In which financial stat. amounts are presented. Mostly, located country s currency. Currency of primary eco. environment. Entity generates & expends cash. Where the company operates. 2.1 Foreign Currency Transaction Exposure to Foreign Exchange Risk Company may expose to exchange rate on transaction (transaction exposure). in value F.C assets or liab. from F.C transaction G/L in I.S (both & ) Transaction Exposure Import Purchase Export Sale F.C may appreciate at payment date. More functional currency to buy F.C. F.C may depreciate at payment date. Less functional currency units after conversion Accounting for Foreign Currency Transactions with Settlement before Balance Sheet Date Basic principal all transactions at spot rate on transaction date. F.C risk when transaction & payment date differ Accounting for Foreign Currency Transactions with Intervening Balance Sheet Dates B.S date fall b/w transaction date & settlement date. F.C transaction unrealized G/L in I.S. at B.S date. Transactions B.S date to transaction date G/L are recognized. G/L of both periods must equal to total actual G/L. Exchange rate causes F.C. transaction G/L as; Export Sale Import Purchase Asset (A.R) Liability (A.P) Strengthens Weakens Strengthens Weakens Gain Loss Loss Gain

16 Study Session # 6, Reading # Analytical Issues Neither standard indicate where in I.S, F.C. transaction G.L should be placed. Two most common treatments Other operating I/E. Non operating I/E, part of net financing cost (some cases). Operating profit margin affected by the placement (no guidance from standards). Comparison may distorted b/w companies. Analyst also concern about unrealized F.C transaction G/L in I.S. 2.3 Disclosure Related to Foreign Currency Transaction Gains and Losses It is useful for companies to disclose. Amount of F.C. transaction G/L (both standard requires). Presentation alternatives (no specific requirement). Companies often neglect to disclose location or amount of G/L (if immaterial). Several reasons for immaterial G/L (e.g. limited transaction, G/L offsetting, hedging activities). in F.V of undesignated hedges in other income (amounts not disclosed). 3. TRANSLATION OF FOREIGN CURRENCY FINANCIAL STATEMENTS 3.2 Translation Methods Companies have Operations in foreign countries. Consolidated financial statements under both standards (require currency translation). Both IASB & FASB have very similar rules for translation. Current rate method Two Approaches Monetary/Nonmonetary method 3.1 Translation Conceptual Issues While translating two questions must be addressed. Appropriate exchange rate for translation. How is B.S. brought back into balance. All A & L at current rate Variation Temporal Method Two approaches for translation A&L All A&L at current exchange rate. Monetary A&L current rate. Nonmonetary A&L historical rate All Assets and Liabilities Are Translated at the Current Exchange Rate F.C balance Sheet A/c,s are revalued in term of functional currency at current exchange rate. Negative translation adjustment not results in cash outflow. Issue whether unrealized translation G/L in I.S. or equity Only Monetary Assets and Monetary Liabilities Are Translated at the Current Exchange Rate Only monetary assets & liabilities are at current rate. Same issue as in (translation adjustment is unrealized, whether G/L to I.S. or equity) Foreign Currency Is the Functional Currency Funct. currency different from parent presentation currency C.R method. All A&L at C.R equity at H.R. R&E at Avg rate. CTA keep B.S. balance under C.R method. Entire investment exposed to translation G/L. C.R. method results in net assets exposure (except negative equity case). When F.C in value positive CTA & vice versa. Measurement basis preserved. A&L at F.C. B.S at C.R translated at C.R. A&L at F.C. B.S. at H.R translated at H.R Appropriate method depends on funct. currency. Certain indicators to determine funct. currency (similar under both standards). If indicators are mixed than management judgment. Three step translation approach (both standards). Indentify funct. currency Translate F.C. balances to funct. currency use current rate to translate into parents presentation currency Balance Sheet Exposure A&L translated at current rate exposed to translation adjustment. Net asset B.S exposure A> L (translated at current rate). Net liabilities B.S exposure L> A (translated at current rate). Effects of currency fluctuations on B.S. exposure are same as in After initial period CTA is required to keep B.S. balance.

17 Study Session # 6, Reading # Parent s Presentation Currency Is the Functional Currency Temporal method. Term remeasurement under (local currency to funct. currency). Temporal method Procedure Balance Sheet Income Statement Monetary A&L Nonmonetary A&L R&E related to nonmonetary Assets R&E not related to nonmonetary Asset Current rate Measured at H.C translated at H.R. Measured at current value, C.V determination date rate. Rate used for assets Avg. rate Remeasurement G/L in I.S. (assume the G/L will be realized in near future). Monetary liabilities often exceed monetary assets, so net liability exposure. H.R. differs with cost flow assumption as. FIFO LIFO AVG. Inventory COGS Inventory COGS Inventory COGS Recent exchange rate Rate when inventory sold Older exchange rate Rate when inv. sold Weighted Avg. rate Weighted Avg. rate Translation of Retained Earnings Equity translated at H.R under both methods, create somewhat problem in translating retained earnings (different rates). R/E = accumulated previous years income dividends Highly inflationary Economies Cumulative three-year inflation rate> 100% (, similar guidance ). Cease to highly inflationary then funct. currency must decide to choose a method. Approaches for Translation 3.3 Illustration of Translation Methods (Excluding Hyperinflationary Economies) Temporal method Avoid disappearing plant problem. Inflation restated financial statements then current rate method. 3.4 Translation Analytical Issues Two translation methods result in very different amounts due to. Different translation adjustment. Different translation rates. Financial ratios differ significantly (except receivable turnover). Pure ratios (B/S or I/S) are similar before and after translation under C.R method. Mixed ratios are distorted by translation under C.R. method. Translation using temporal method distorts all ratios. Not possible to generalize direction of distortion across ratios. Foreign Currency Strengthens Current Rate Method Temporal Method Income, revenue, A&L, total equity & vice versa. Revenue, A&L, net Income, equity & vice versa.

18 Study Session # 6, Reading # Translation when a foreign Subsidiary operates in a Hyperinflationary Economy Temporal method (). First restatement of financial statement then C.R. method (). Restatement Procedure Balance Sheet Income Statement Monetary A&L Non monetary A&L Equity Restated from item recording date to B.S. date. Net purchasing power G/L in I.S. No restatement H.C. adjusted for in price index if items are at H.C. Restated from date of revaluation if carried at revalued amount. Restated by applying in price level from beg. of period or contribution date if later. Holding monetary assets during high inflation P.P.L. monetary liability P.P.G. Results can be very similar under two different methods. (Similar exposure). Same result if % in exchange rate= in general price index in high inflation. 3.6 Companies use Both Translation Methods at the Same Time A parent company use temporal & C.R method at same time (under both standards). Firms under same industry can use different translation method (judgment in funct. currency). CTA to net income for comparability. 3.7 Disclosures Related to Translation Methods Both standards require two types of disclosure. Amount of exchange difference in net income. Amount of CTA along with reconciliation. Disclosure of CTA amount from equity to income at disposal of entity (). No separate transaction & translation disclosure (under both standards). Dirty-Surplus accounting income items as part of equity rather G/L in I.S (e.g. CTA adjustment). Disclosures provide detail to move from dirty-surplus to clean-surplus.

19 Study Session # 7, Reading # 26 THE LESSONS WE LEARN 1 G/L = Gain & Loss I.S = Income Statement 1. INTRODUCTION Financial reporting transparency involve disclosures that are understandable & reliable. Analyst should focus on quality of information not quantity of information. C.F = Cash Flow B.S = Balance Sheet 2. THE LESSONS LESSON 1: Understand What You Are Looking At Analyst must aware type of disclosure (Pro forma or according to GAAP). Be skeptical when firm s earnings are growing faster than industry & economy over long run. Higher weight to permanent items LESSON 2: Read the Fine Print Footnotes may neither concise nor clear. No standards to the format & readability of the footnotes & MDA, so transparency adds value. LESSON 3: If it s Too Good to Be True, It May Be Value creation comes from competitive advantage. Growth based on debt is not sustainable. Check whether sales growth persist in earnings growth. LESSON 4: Follow the Money Growth of earnings must be justified by the growth of operating C.F. if not firms may engage earning manipulation. LESSON 5: Understand the Risks Two dimensions to understand risks. What they are. How companies deal with these, Types of Risk Types of risks are varied, some are. Foreign exchange risk. Interest rate risk. Price risk. Types of Hedge Fair Value Hedge Cash Flow Hedge Net Investment Hedge of a Foreign Subsidry Use derivatives to hedge fair value of assets or liabilities. Derivative & hedged asset or liability at fair value in B.S. Unrealized G/L I.S, Use derivative to hedge exposure to variable C.F. Derivative at fair value in B.S. Unrealized G/L in equity. Eventually in I.S when transaction effect earnings. Foreign exchange contracts to offset exchange risk of net investment in subsidry G/L from hedge are recognized in I.S. or equity depending on method used (all current, temporal). When in fair value, cash flow, or net investment is exactly offset by changes in the hedging instrument, hedge is called effective hedge.

20 Study Session # 7, Reading # THE FUTURE OF FINANCIAL ANALYSIS IN THE POST-SOX ERA Sarbanes- Oxley act provide oversight of: Auditing function. Increase disclosures. Improved corporate governance. Reduce conflict of interests.

21 Study Session # 7, Reading # 27 EVALUATING FINANCIAL REPORTING QUALITY 1 R&D = Research & Development SGA = Selling, general & Admin FV = Fair Value G&S = Goods & Services C.F.S = Cash Flow Statement F.S = Financial Statements B.S = Balance Sheet 1. INTRODUCTION Financial reporting quality accuracy of operating performance. More discretion usually low reporting quality. O.L = Operating Lease G/W = Goodwill A&L = Asset & Liability AR = Accounts Receivable DSO = Days Sales Outstanding COGS = Cost of Goods Sold LIFO = Last-In-First-Out NOA = Net Operating Assets 2. DISCRETION IN ACCOUNTING SYSTEMS 2.1 Distinguishing Cash Basis from Accrual Basis Accounting Accounting Basis Cash Basis Accrual Basis Only cash transactions Revenue when provide G&S to customers. True value-creating activities. More timely & relevant information. Lower weighting than cash components (otherwise securities mispriced). Less persistent (more estimates). 2.2 Placing Accounting Discretion in Context Reliability of earnings due to estimation error or manipulation. Choices made to overstate income future C.F. will be. Dep, Inventory, revenue recognition, taxes, pensions & stock options are some examples of accounting discretion. Discretion can combined with real business decisions. 2.3 Manipulation Incentives Capital Markets Contracts Reported financial information has affect on security prices, so firms may engage in manipulative behavior. Forecast error = firm s reported earnings sell side earnings forecast. Firms engage earnings expectation management (encourage lower forecast) & earning game (reported earnings meet estimates). Managerial & financial securities contracts provide incentive for management to use discretion (e.g. executive compensation, debt covenants). 2.4 Mechanisms Disciplining Management Many mechanisms curtailing abuse of discretion include. External auditors (independent opinion by registered auditors). Internal auditors (check on management). Management certification (CEO & CFO certify financial statements). Lawyers, regulators & market scrutiny. 3. FINANCIAL REPORTING QUALITY: DEFINITIONS, ISSUES, AND AGGREGATE MEASURES Earning quality persistent & sustainable or aggressive or conservative (poor measure, accruals have self correcting property). 3.1 Mean Reversion in Earnings Extreme earnings revert to mean level. Used in C.F forecasting. Accrual earnings quicker mean reversion.

22 Study Session # 7, Reading # Measures of the Accrual Component of Earnings and Earnings Quality No disputing ownership & valuation of cash except fraud. Comparing cash basis F.S with accrual basis identifies extent of discretion. Aggregate accruals = accrual basis total earnings cash earnings. Accruals C.F is preferred approach consider effect of noncash acquisition & currency translation adjustment. NOA t = [(Total assets t cash t) (total liabilities t total debt t)]. Current V/S noncurrent accruals = diff. b/w income & operating C.F for current accruals. Compare companies using same method. Accruals B.S. Based C.F. Based Accrual ratio adjusts diff. in company size. Analysts adjust treatment diff. of interest & dividend under both standards. 3.3 Applying the Simple Measures of Earnings Quality Accrual methods measure discretion on aggregate basis (not component accrual). Lower accrual ratio, higher earning quality & vice versa. More detail analysis components of accruals. 4. A FRAMEWORK FOR IDENTIFYING LOW-QUALITY FINANCIAL REPORTING Relevance of reporting quality measures. Varies across companies. Can vary through time. Sector neutralizing = given company ratio- mean or median ratio for given sector. Homogeneity & size difference must consider when making comparisons. 4.1 Revenue Recognition Issues Include mis-stating revenue, early recognition & nonoperating revenue to operating Revenue Mis-statement Over or understatement of revenue for a given period Accelerating Revenue Discretion as to when a sale has been made The Range of Problems The Range of Problems Total revenue = cash collected + AR - unearned revenue. Discretion over uncollectible, unearned revenue, warranty provisions & sales return may cause revenue recognition issues. Revenue is recognized when good is delivered or service performed. Goods & services as bundled products revenue may accelerate Warning Signs Large in A.R or unearned revenue low-quality revenue. DSO= Net A.R 365 DSO, red flag (check credit policy & securitization). T.R

23 Study Session # 7, Reading # Warning signs Focus revenue reporting practice when, Management has in-the-money options. Raise additional financing & track analyst forecasts. Similar warning signs as for overstated revenue. Analyze ratio of revenue to cash collected from customers (should stable) Deferring Expenses The Range of Problems Capitalizing costs that should expensed Warning Signs 4.1.3Classification of Nonrecurring or Nonoperating Revenue as Operating Revenue Investors focus on operating income incentive to include nonrecurring revenue in operating income The Range of Problems No ex-post settling up mechanism (no reversals). Number provided to capital markets earnings before bad stuff Warning Signs Check pro forma earnings (exclude items for its computation). 4.2 Expense Recognition Issues Include understating, deferring & classifying ordinary exp as nonrecurring Understating Expenses Improper capitalization of costs. Growth in NOA future Performance (excess capacity & deteriorating margins) Classification of Ordinary Expenses as Nonrecurring or Nonoperating To mask a decline in operating performance The Range of Problems Inappropriate classification of recurring item. Mostly, companies with deteriorating core Core operating margin = sales COGS SGA Sales In margin look for negative special items. Reclassification tendency, when incentives are higher, irregular special items reporting. 4.3 Balance Sheet Issues Off-balance sheet debt & G/W Warning Signs off-balance Sheet Liabilities The Range of Problems Assets from off B.S financing affect on-balance sheet accruals. Dep. & amortization considerable discretion (which cost to capitalize, residual value, useful life & allocation method). Obsolescence of inventory must consider Warning Signs Financial reporting quality not limited to F.S. (additional information should consider e.g. conference calls). Monitor large changes in inventory. Days inventory outstanding ratio= Net inventory 365 in ratio potential problem. COGS Check footnotes for LIFO liquidation The Range of Problems Less leverage if certain A&L remain off-balance sheet (e.g. leases). Lease can be structured as operating or finance lease (certain criteria e.g. useful life, PV of lease payments). Companies have strong preference for operating lease (off.b/s) Warning Signs Check disclosures regarding operating lease to identify future C.F. obligations. Track year-over-year changes in off-balance sheet leases.