CFA Level 1 (2009) - 3

Study Session 10

Cross-Refercnce to CFA Institutc Assigned Reading #42 - Financial Statcmcnt Analysis: Applications

I.Thc table bclow shows sc1ened data from a conlpany's financial statemcnrs.

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Credit analySts are likely to if the company reduces its:

A.scale and diversification.

B.margin stability.

C.leverage.

4.Which of the following stock screens is most likely to identify srocks with high earnings growth rates?

A.Dividend payout ratio> 30%.

B.Price to cash flow per share ratio < 12.

C.Book value to market value ratio < 25%.

5.An analyst needs to compare the financial statements of Firm X and Firm Y.

Which of the foHowing differences in the tWO firms' financial reporting is least

likely to require the analyst to make an adjustment'

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Thc following is a rcvicw of (hc Financial Rcponing an,l Analysis principlcs dcsigncd to aJ,lrcss (hc Icarning olltcomc statemcnts set forth by CFA Instilnlc<V. This 10 pic is also covcrcd in:

INTERNATIONAL STANDARDS CONVERGENCE

Study Sessioll 10

EXAM Focus

LJ)S (i.Ll: IdentiFy and explain the major international accounting standards for each ~lssel and liability category on the balance sheet 3.ncl the key differences from U,S. ge:1cLdly accepted ar.:counting principles

The elcl11cl1ls 01'the balallcc sheet (;ISSCtS, li~ll)iljtics, and equitl") HC dclincd in rill' 1!\~IL cunc'Ttu~d framework. According 10 the fral11c\\'(Hk, feH an ill'm 10 bc recognilccl on rh,' h:dance sheet ;IS ,In asset (Ii:lhilit)·), ir {llUSt he prohahle tlLlI a flIlUl'C ccono111ic ['l'nclir (opcll\e) \\ill How ro cll" frol11 the (11'111 'Ilid rhe itclll\ cosr can be reliahly Il1casur<::d. Concepllullv, equity is simply assets minus liabilities.

Marketable [nycstment Securities

:\larketable illl'eSlll1el1l sccuriries arc initi:11ly rccorded on lhc bahnce shcer at cosr; that is, the L1ir valuc at the date of acquisition. The main issue involves wherher to adjust the balance sheer to reHcct subsequent ch:lnges in fair value. The adjustmenls depend on rhe classification of thc securities.

As discussed in the ropic rcview on undcrstanding the balance sheet, marketable

For-sale under SFAS No. 115, Under lFRS, tile :\ccou'lling for I11HkeLlhle inl'cS!l1H'!H securilies is \iIlU:llly rhe s~\me. One JiJTercnce is th~ll trading securities ~lIe knoll'n as "held-for-lr:rding" securities under JF1~S.

Held-ro-maturity securities are debr seCllriries acquired with the intenr and ability to Oll'n lhelll until they mature. l-lcl,l-tu-I11:11urilY securities arc I"eporll'd on the

bal:lnCl' sheer :ll :ll11oni'l.ed cos!. An1Orri7.eJ cost is eClllal III the race (p:1I") v,llue less any

©2008 Kaplal1 Slhwcser

Study Session 10

Cross-Reference to CFA Institllle Assigned Reading #43 - Illlernational Standards Convergence

unamortized discounr or plus any unalllOrti/.ed premium. Suhsequem changes in fair value arc ignored unless the sc.lcurity is sold or otherwise disposed of.

Held-for-trading securities arc debt and equity securities, including derivalives, acquired with the imenr to profit from ncar-term price fluctuations. Held-for-trading securities arc reponed on the balance sheCt at elir valuc. Unn:ali/.cd gains and losses (changes in markel valuc Lw(ore the sccurities ;lrl' sold) arc n:cogni/.ed in the income SCllement.

Available-for-sale securities arc debt and equity securities that a firm docs not expeu to hold untilmarurity nor expecc to trade in the ncar term. Like held-for-trading securities, avaiJabl<:-for-sale securities arc reponed on the balance sheet at fair value. However,

any unrealized gains or losses arc not recognized in the income statement. Rather, any unrealized gains or losses arc reponed as o( her comprehensive income.

Regardless or a security's classiflcHion, dividend inu)me, inrcrest income, and any reali:t.L:d gaillS ~lnd !oss<:s (auual gaillS or losses reLnive to carrying valuLS reali/.cd when \l'C1lrilics ~lI'c solei) ,Irc' rec'ognized in lhl' incomc SLllemenl.

hgure I summarizes the differences among the treatments of the thrce categories of marketable securities on th<: balance sheet and inc'ollle statement.

Figure 1: Summary of Marketable Investment Security Classifications

Example: Classification of investment securities

Triple D Corporation purchased a 6% bond, at par, for $1,000,000 at the beginning of the year. Imerest rates have recently increased, and the market value of the bond declined $20,000. Determine the bond's treatment on the financial statements LInder each classification of securities.

Answer:

If the bond is classified as a held-ta-maturity security, the bond is reported on the balance sheet at $1,000,000 and imerest income of $60,000 [$1,000,000 x 6%] is reponed in the income statement.

If the bond is classified as a held~for-trading security, the bond is reported on the balance sheet at $980,000 and the $20,000 unrealized loss and $60,000 of interest income arc both recognized in the income statemem.

Study Sessiou 10

Cross-Reference to CfA Institute Assigned Reading #43 - International Standards Convergence

If the bond is classified as an avai/rlble-for-sale security, the bond is reponed on the babn~esheet at $980,000 and $60,000 of interest income is recognized in the income statement. The $20,000 unrealized loss is not recognized in the income statement; rather, it is reponed as other comprehensive income and decreases stockholders' equity.

The performance of held-for-trading securities is more rransparelH .since both unrealized gains and unrealized losses are recogni'l.ed in the income statement. Conversely, there

is asymmetric treatment with available-for-sale securities since the unrealized gains and losses bypass the income statement and are reponed as a direct adjustment LO equity. By bypassing the income statement, the performance of available-for-sale securities (an he misil1lerpreted by analysts. If a firm owns an equity security classified as available-for- sale, cOlHinuing decn:ascs in share prices do not affect the income statement as long as the security is not sold.

Finns thar follow J FRS arc required to 11l;\ke qualirative and tju;lI\titarive disclosures abour credir risk, liquidity risk, and marker risk, Qualitative disclosures provide information about managing the risks and quantitative disclosures deal with rhe amounr of risk.

Inventory

Under IFRS, the choice of inventory method is based on the physical flow of the inventory; that is, whether the inventory that is purchased or produced first, is sold first. Two acceptable methods are the firSt-in, nrst-out (FIFO) method and the average cost method. Recall in the topic review on understanding the income sratemenr that the lastin, nrst-out (LIFO) method is allowed under U.S. GAAP but is not permirrcd under IFRS.

Under IFRS and U.S. GAAP, inventory is reported on the balance sheet at the lower of cost or net realizable value. In the United States, once an inventory write-down occurs, any subsequent recovery of value is ignored. Under IFRS, subsequenr recovery in the value of inventory can be included in inventory values.

Property and Equipment

Under IFRS and U.S. GAAP, property and equipment, sometimes referred to as fixed assets, are reported on the balance sheet at original cost less accumulated depreciation, U.S. GAAP does not permit upward revaluations of property and equipment.

Under IFRS, property and equipmenr can be revalued upward. In this case, the property and equipment are reported at fair value at the revaluation date less the accumulated depreciation since revaluation.

The increase in value is reponed in the income statement to the extent that a previous downward valuation was included in net income. Otherwise, any increase in value is reported as a direct adjustment to equity. This results in consistent treatment in the

Stlldy Session 10

Cross-Reference to CFA Institute Assigned Reading #43 - International Standards Convergcncc

inconw statell1enr. Similarly, a decrease in value is reponed as a loss on the income sc!tcmeIH unless it reverses a previous upward revaluation taken direcdy to equity.

Intercorporate Investments

When a firm makes an equity investIHent in another (irm, [he accouIHing lIeallllent depends on the firm's ability [() inliuence or cOl1lrol thc policies ~lnd actions of the investee. The classific.llion of marketable equity securities as hcld-fi.H-rrading and available-for-sale only applies (0 passive investments. An investment is considered passive if rhe invesror cannot significanrly influence or control rhe invesree. As a practical guideline, an ownership interest of less than 20°/<) is considered passive.

If an ownership interest is between 20% and 50%, the investor can usually signif1canrly influence the invcsree. Under IFRS, significant influence is defined as rhe pown [() participate in the financial and operating policy decisions of rhe inVl'stee without cOIHrol or joint conrrol over those policies.!

For investmel1ls over which they have significant in{\uence, firms musr use [he equity method of accouIHing. Under the equiry merhod, a pro-rara share of rhe investce's nct income is reponed as invesrment income and increases rhe reponed value of the firm's equiry investmenr. Dividends received from the equity investmenr decrease the reported value of the investment (but increase cash).

If an ownership interesr is greater than 50%, the invesror can usually control the investee. In this case, the consolidation method must be used, and the firm repons alt of the assets and liabilities, as well as the net income, of the investec in irs own financial statemen t Items.

In the casc of joint control of an investce, such as an ownc-rship intcrest in a joint venture, I FRS recommends the use of the proportionate consolidation method. Under proportionate consolidation, the investor repons its pro-rata share of the assers,

liabilities, and ncr income of the investee. Alrernatively, the equity method can be used, hut proportionate consolidarion is preferred.

Under U.S. GAAP, the equity method is usually required for joint ventures.

Proportionate consolidation is permitted under IFRS only.

figure 2 summarizes the accounting treatment for intercorporate investments.

1. TIHernarional Accounting Standard No. 31.

Goodwill

Recall from the ropic review on understanding the balance sheel that goodwill is the ('XCl's.' ofpurchasc price OILT the L\ir v;II\1e oCthe' idelllifiahlc assets and lial)ililics :!l"tluired ill a busincss acquisition. (;oodwill is an unidentifiahle illLlllgihk asset tlLll unllor bc separated from the firm.

Goodwill is not systematically amortized in the income statement but is tested at least annually for impairment. If impaired, goodwill is written down on the balance sheet and the consequent loss is recognized on the income starement. The impairment of goodwill docs not affect cash flows, but docs affect certain financial ratios. In periods after a

write-down, ratios such as ROA, ROE, and asset turnover will improve because the denominator of each is reduced.

]udgmcl1l is involved iu determining whether goodwill is impaired. Of course, when judgment is involved, there ;ue opportunities (or the firm [0 manipulatc earnings.

For comparability, analysts often make the following adjustmcnts:

Completely eliminate goodwill whcn computing ratios.

Exclude goodwill impairmcnt charges from the incomc statement when analY2.ing trends.

• Evaluate future acquisitions in tcrms of the pricc paid rchtive to the carning power of the acquired assets.

Two other issues affect the comparability of the financial statements of the acquiring firm in a business acquisition.

1.The assets and liabilities of the acquired firm are recorded at fair value at the date o( acquisition. As a rcsult, the acquiring firm reports assets and liabilities with a mixture of bases for valuation; old assets contillue to be reported at historical cost while acquired assers are carried at their fair value.

2.The revenues and expenses of the acquired firm arc included in the acquiring firm's income statementftom the acquisition date. There is no restatement of prior-period income statements. Without restatement, aClJuisitions may create an illusion of growth.

Study Sessiun 10

Cross-Reference to r;FA Institute Assigned Reading #4:, - International Standards Convergence

ldenriflable Intangible Assets

Undcr U.S. CAAP and IFRS, purchased intangible assets arc reponed Oil the balancc shcet at their cost less accumulated amorrization. The costs of internally devel0lled inungibles arc gcnerally expcnscd as incurred. U.S. CAAP docs nol pcrmil upward rl'v;lluatiuns 01" inrangiblc assns.

!\s with property and eLJuipmenl, IFRS docs allow upward rcvaluations of idenriliable intangible assns. Inrangible asscts arc thcll reponed at their flir valuc as of lhe revaluation datc, less the accuI1lulated aI1lortii.ation sincc revaluation.

As with properry and cquipmenl, any increasc in valuc is reponed in the illLome Slall'l1\enl 10 the extent thaI a previous downward revalnalion reduced net incolllc. I\n)' upward revaluation jn excess 01" prior dowllward revalualion is reportcd as a direcl adjllstnlelH 10 equity. Under the samc principle, a decrease in value is reported in the il!Lomc SlalL'!1lellt to the extent dl~n J IHevious ullward [evaluarion was included in nel

inco!lle, and ~lny decrease in V~t1Ul' in exCl'SS or prior upw;lId rev;tltLllion is rep0rll'll ;IS a llircCl adjuslllll'nl 10 equil),.

Analysrs musr be aware that not all inrangible assns are reponed on the balance sheer. SOllle intangibles ;He expensed as incurred. These unrccorded aSSClS IllUSI srill be lonsidered when valuing a I1rm. A valuable brand name such as Coke(i,j, lhe soFtware developed by Microsoft Cor[lor;nion, or the pJtenlS and manufacturing experlise of J large pharlllacelllical I1rm may not be recorded as I1rm assers.

Provisions

Provisions arc nonfinancial liabiliries that are uncertain as to their timing or amount. Examples include warranty obligations and contingencies. According to lAS No. 37, a f1rm should recognize a liability when it has a present obligation that is a result of a past event and the firm can reliably cstimate the cost to settle thc obligation.

U.S. CAAP docs not use the tcrm "provisions." Under U.S. GAAP, if a contingency is probable and can be reasonably estimated, a loss is recognii,ed in the income statement and a liability is recorded on the balance sheer.

LOS 'D.b: identify and explain the major international accounting standards for major ITvenuc and expense categories on the income statement, and the key differences from U.S. CAAP.

The definitions of reveIlue and the criteria for revenue recognition under U.S. CAAP and IFRS differ slightly. The main principles are the same but U.S. GAAP provides more industry-specific guidance than IFRS.

Study Session 10

Cross-Reference to erA Institute Assigned Reading #43 - International Standards Convergence

Construction Contracts

Under U.S. CAAP, the percentage-of-completion method of revenue recognition is appropriate for contraCts that eXlend beyond one accounting period ir the outcome of

I he project can be reasonably estimatcd. Accordingly, revenll<:, expens<::, and therefore profit arc recognized as the work is l)erformed. II' the outcome of project cannot be reasonably eStimated, the completed-contract method is required.

Under lFRS, if the firm cannot reliably measure the outcome of the projeCt, revenue is recognized to the extent of contract COStS and profit is only recognized at project com pletion.

Cost of Goods Sold

IFRS does not pl'lmit LIFO inventory accoulHing. LIFO firms that follow U.S. CAAP must disclose the LI FO reSClve in the footnutes to their financial statemeIHS. The change in the LlH) resClVC over ,I period of timc is equal to dll' diffcrence between coes ulculated lIndl'l uro and coes cdculated under FIFO. Disclosure ofthe UFO reserve allows usns [() adjust the UFO COGS to FIFO COCS. This adjustmellt enhances the comparability U.S. ancl lFRS firms.

Operating Expenses

U.S. GAAP differentiates between expenses and losses, but IfRS docs nor. Under IFRS, losses not related to a firm's primary business operations arc included in operating expenses.

Depreciation

Tangible assets (excluding land) are depreciated, intangible assets (except goodwill) are amortized, and natural resources are depleted. All three terms describe the allocation of an asset's cost over its useful life. The allocation process requires the use of estimates such as useful life and salvage value. Estimates often change as new information is

acquired. A change in an estimate is put into effect prospectively; that is, no cumulative adjustment is made for prior period depreciation, just as with U.S. GAAP.

In choosing an appropriate allocation method (e.g., straight-line, accelerated), IFRS requires that the method reflect the pattern of expected consumption and the allocation must be made on a systematic basis over the asset's useful life.

Interest Expense

Borrowing costs are generally expensed in the yeat incurred. Under IFRS, firms can choose to capitalize interest that is related to the acquisition, construction, or production of an asset that will take a substantial time to complete. The capitalized interest is simply added to the cost of the asset and is eventually recognized in the income statement as the asset is depreciated.

Firms that follow U.S. GAAP must capitalize construction interest.

Srudy Session 10

Cross-Reference [0 CPA Institute Assigned Reading #43 - International Standards Convergence

Income Taxes

Borh U.S. CAAP and IFRS rcquire firms to rccognizc rcmporary differcnccs hnwccn 11nancial rcponing srandards and rax reporting srandards. Thcse diffcrences can crearc both dcferred tax assers and deferred tax liabilities.

The differences berween II;RS and U.S. eMP in accounring f()I' income taxes relarc primarily ro diffcrences and exceptions in financial accoullling principles bctwecn U.S. GAAP and IFRS.

Nonrecurring Items

Analysts often ignore nonrecurring items when forecasting future earnings because rccurring e:unings arc usually viewed as more sustainahle. Over the pasr sever:ll years, there has heen convergence berween U.S. CAAP and IFRS in rcponing discol1linued operarions ~lI1d changes in accoul1ling princif)les. However. [hcir trearmcl1lS of c:xrraordinary irems still diller.

Under U.S. GAAP, an extraordinary ircm is a marerial transacrion thar is borh unusual in nature and infrequcnr in occurrence. Extraordinary irems are reponed in rhe income srarcmenr, ncr of rax, below income from continuing operarions.

IfRS does nor permit firms ro treat items as "extraordinary" in the income statement. The analyst, however, can use required IFRS disclosures ro separate recurring and non-

dividelHh 011 the cash How statement.

Under U.S. GAAP, dividends paid lO rhe firm's shareholders are reponed as CFF and inreresr paid is reponed as CFO. Interest received and dividends received from investments are also reported as CFO.

IFRS allows more flexibiliry in the classification of interest and dividend cash flows. Under IFRS, inrerest and dividends received may be classified as either operating or investing activities (CFO or eFJ). Dividends paid to the firm's shareholders and interest paid on the firm's debt may be classified as either CFO or CFF.

j,O:'; ,'j3,d: Int r 'rprc1.. the dTcct ofdirrcrellccs between international and U.S.

C!\AP :1ccountinlT, standards on the balance sheet, income statement, and the s1.aU.'11lt'1l1 of ch:mgcs iii c{jllity for some commonly used financial ratios.

When comparing firms that follow different accounting standards, rhe analyst must make adjustments to the specific balance sheet and income statement accounts that differ. This is done by recasting the financial statements of one of the firms so that the financial statements of both firms can be compared.