Financial Statement Analysis

Investments in financial assets.

Investments in financial assets. An ownership interest of less than 20% is usually considered a passive investment. In this case, the investor cannot significantly influence or control the investee.

Investments in associates

Investments in associates. An ownership interest between 20% and 50% is typically a noncontrolling investment; however, the investor can usually significantly influence the investee's business operations. Significant influence can be evidenced by the following:

• Board of directors representation.

• Involvement in policy making.

• Material intercompany transactions.

• Interchange of managerial personnel.

• Dependence on technology.

Business Combinations

Business combinations. An ownership interest of more than 50% is usually a controlling investment. When the investor can control the investee, the acquisition method is used.

It is possible to own more than 50% of an investee and not have control. For example, control can be temporary or barriers may exist such as bankruptcy or governmental intervention. In these cases, the investment is not considered controlling.

Conversely, it is possible to control with less than a 50% ownership interest. In this case, the investment is still considered a business combination.

Joint Venture

Joint ventures. A joint venture is an entity whereby control is shared by two or more investors. Both IFRS and U.S. GAAP require the equity method for joint ventures. In rare cases, IFRS and U.S. GAAP allow proportionate consolidation as opposed to the equity method.

Reclassification under IFRS 9

NO UNLESS BUINSESS REMODEL:
Amort → FVPL

• unrealized G/L recognized in income statement

FVPL → Amort

• transferred at FV on transfer date, and FV will become carrying amount and amortize from there

Loan Impairment under IFRS 9

MUST ESTIMATE LOSTS FORWARD LOOKING 12M and LIFE TIME EXPECTED LOSSES FOR NON PERFORMING LOANS

When can we use Equity Method at Fair Value

• US GAAP - allows investments to be recorded at fair value

• IFRS only allows for VC firms, MF, and similar entities

  • only those who can accurately measure FV with modeling

What are the 3 analytical problems with the equity method?

• Earnings inflated — reports % of full earnings, not just dividends received

• Debt hidden — investee's liabilities buried in one balance sheet line

• Margins distorted — investee profits included but revenues excluded

Upstream vs. Downstream — what gets eliminated and how?

Both eliminate unconfirmed profit using the same formula:

Total Profit × % Unsold × % Ownership

• Upstream = investee sold to investor (profit in investee's books)

• Downstream = investor sold to investee (profit in investor's books)

U.S. GAAP vs. IFRS on impairment of equity method investments?

	GAAP	IFRS
Trigger	Fair value < carrying value AND other-than-temporary	One or more loss events
Reversal	❌ Never	✅ Allowed

what acctg method of business combinations

acquisition method

IFRS goodwill impairment

CV - FV or Recoverable amount

GAAP goodwill impairment

1. CV > FV

2. FV - FV net intangible assets = implied goodwill

3. CV - implied W = impairment loss

Proportionate Consolidation Method

It is an accounting method where the investor, also called the venturer, reports only its proportionate share of a joint venture's assets, liabilities, revenues, and expenses, rather than the full 100%.

Why no minority interest? for proprotionate consolidation method

Since only the venturer's own share is recorded line by line, there is no outside ownership being consolidated in, which means no noncontrolling interest account is needed.

What is a special purpose entity (SPE)?

A legal structure — which can take the form of a corporation, partnership, joint venture, or trust — created to isolate certain assets and liabilities of the sponsor. The typical motivation is to reduce risk and lower the cost of financing by ring-fencing risky assets away from the sponsor's main balance sheet.

Who must consolidate a variable interest entity (VIE), and why?

The primary beneficiary must consolidate the VIE — defined as the entity that absorbs the majority of the risks or receives the majority of the rewards. This is regardless of how much equity it technically owns. The reasoning is that FASB shifted from a rules-based approach (who owns the most votes) to a substance-based approach (who really controls and bears the economic risk), closing the loophole companies used to keep SPE debts off their balance sheets.

How are contingent liabilities treated at acquisition under IFRS vs U.S. GAAP?

Under IFRS, contingent liabilities are recognized only if their fair value can be reliably measured — contingent assets are never recognized. Under U.S. GAAP, contractual contingent items are recorded at fair value, while noncontractual ones are recorded only if it is more likely than not they meet the definition of an asset or liability.

What is contingent consideration and how is it treated subsequently?

Contingent consideration is an extra payment promised to former shareholders if certain targets are met after acquisition — like an earn-out. Both IFRS and U.S. GAAP recognize it at fair value at acquisition. Subsequent changes in value go through the income statement, unless it was originally classified as equity, in which case changes stay within equity.

How is in-process R&D treated in a business combination?

In-process R&D is capitalized as an intangible asset on the acquisition date under both IFRS and U.S. GAAP — it is not immediately expensed. Subsequently it is amortized if the project succeeds or impaired if it fails.

How are restructuring costs treated in a business combination?

Restructuring costs are expensed as incurred under both IFRS and U.S. GAAP. They cannot be capitalized as part of the acquisition cost. This prevents companies from burying post-acquisition restructuring charges inside the acquisition price to avoid hitting the income statement.

Where is employee compensation expense reported on the income statement, and what is the exception for unsold inventory?

Compensation is never shown as a separate line — it is embedded in the relevant expense category based on the employee's role. Factory workers go into cost of goods sold, research employees into R&D, selling staff into selling expense, and administrative staff into G&A. The exception is compensation related to unsold inventory — it is capitalized on the balance sheet as part of ending inventory and only flows to the income statement through cost of goods sold when the inventory is eventually sold.

What are the four vesting condition types and the key equity instruments in share-based compensation?

Service condition — employee must remain employed for a specified number of years before the grant vests.

Performance condition — grant vests upon hitting a specific financial target such as an EPS threshold.

Market condition — grant vests based on a market metric such as the stock price reaching a certain level.

Performance shares — restricted stocks that vest based on a performance condition.

Restricted stock units (RSUs) — promises to deliver shares upon vesting rather than upfront. No exercise price, always worth something above zero, no dividends during vesting period, simpler tax treatment than options.

Stock options — nontradeable call options where the employee profits from the difference between stock price and exercise price. Require a cash outlay at exercise and can expire worthless if out of the money.

Stock option w/ tax benefits - windfall,shortfall

When stock price rises — tax windfall

If the stock price is higher at settlement than at grant date, the tax deduction the company claims is larger than the compensation expense it already recorded. The company gets more tax relief than it expensed. This excess tax benefit is a windfall that flows through equity.

When stock price falls — tax shortfall

If the stock price is lower at settlement than at grant date, the tax deduction is smaller than the compensation expense already recorded. The company gets less tax relief than it expensed. This creates a tax shortfall.

What are the three problems share-based compensation creates for financial forecasting and valuation?

Problem 1 — It is hidden. Share-based compensation is buried inside COGS, R&D, and SG&A rather than shown as its own line. If expense-to-revenue ratios are stable, leave it embedded. If ratios are shifting, strip it out and forecast it separately using history, management guidance, or industry averages.

Problem 2 — It inflates free cash flow. Because it is noncash it gets added back in operating cash flow. A company paying employees in stock shows higher FCF than an identical company paying in cash, making it look artificially cheap on P/FCF multiples. Analysts must adjust for this when comparing companies.

Problem 3 — It dilutes shareholders. Every option exercise or RSU vest creates new shares. For existing grants use the reported diluted share count. For future grants estimate dilution using a dilution factor or projected share increase.

Treasury Shares

Treasury shares are shares the company has bought back from the open market and holds on its balance sheet. They carry no voting rights or dividends and reduce shares outstanding.

What are the two key valuation issues with diluted EPS?

• Loss-making companies — Basic = Diluted EPS (anti-dilutive securities excluded), but analysts should manually add them back for valuation since future profits will activate dilution.

• Declining share price — Treasury stock method uses average price, understating dilution; analysts should factor in future stock appreciation raising the average price.

What are the three forecasting issues when dealing with dilution?

• Forecast the expected increase in shares outstanding.

• Future grants — estimate dilution by discounting equity value by a dilution factor, or estimating new shares issued.

• Cash flow ratios — companies with high noncash compensation show inflated free cash flow vs. peers; adjust when comparing.

How is past/prior service cost treated under U.S. GAAP vs. IFRS?

• U.S. GAAP — Recorded in OCI, then amortized over employees' remaining service life (never hits P&L immediately)

• IFRS — Recognized in P&L immediately, no amortization

How are actuarial gains/losses treated under U.S. GAAP vs. IFRS?

• IFRS — All go to OCI, never amortized (stay there permanently)

• U.S. GAAP — Go to OCI first, but amortized to P&L using the corridor approach:

  • If cumulative actuarial gains/losses exceed 10% of the greater of beginning PBO or plan assets, the excess is amortized over employees' remaining service life

  • Gain amortization reduces pension cost; loss amortization increases it

What causes actuarial gains/losses?

• Changes in actuarial assumptions (e.g., discount rate, life expectancy) → affects PBO

• Actual vs. expected return on plan assets differing

What are the three currencies in multinational accounting?

• Local currency — currency of the country where the entity operates

• Functional currency — currency of the primary economic environment where the entity generates/expends cash; determined by management; may or may not be the local currency

• Presentation currency — currency the parent company uses to report its financial statements

How are foreign currency transactions accounted for?

Basic rule: Record at spot rate on transaction date; any change between transaction date and payment date = gain/loss on income statement

What are the two translation methods and when is each used?

• Temporal method — converts local → functional currency (used when they differ)

• Current rate method — converts functional → presentation currency (used when they differ)

How are items remeasured under the temporal method?

Rate Used	Items
Current rate	Monetary assets & liabilities (cash, receivables, payables, debt)
Historical rate	Nonmonetary assets & liabilities (inventory, fixed assets, intangibles, deferred revenue)
Historical rate	Common stock, dividends paid
Historical rate	Expenses tied to nonmonetary assets (COGS, depreciation, amortization)
Average rate	Revenues and all other expenses

How does inventory cost flow affect remeasurement under the temporal method?

Method	Ending Inventory Rate	COGS Rate
FIFO	Recent historical rates (newest purchases)	Older historical rates
LIFO	Older historical rates	Recent historical rates (newest purchases)
Weighted average	Weighted average rate for period	Weighted average rate for period

Under the current rate method, what rate is used for each item?

Average rate for income statement items; current rate for all balance sheet items except common stock (historical rate) and dividends (rate when declared). Translation gain/loss goes to equity as CTA, not the income statement.

Summary of Temporal Method and Current Rate Method

	Temporal Method	Current Rate Method
Monetary assets and liabilities	Current rate	Current rate
Nonmonetary assets and liabilities	Historical rates	Current rate
Common stock	Historical rates	Historical rates
Equity (taken as a whole)	Mixed*	Current rate**
Revenues and SG&A	Average rate	Average rate
Cost of goods sold	Historical rates	Average rate
Depreciation and amortization	Historical rates	Average rate
Net income	Mixed rate*	Average rate
Exposure	Net monetary assets	Net assets
Exchange rate gain or loss	Income statement	Equity

Under the temporal method, why does an appreciating local currency typically cause a loss?

Because most firms have net monetary liability exposure under the temporal method — monetary liabilities exceed monetary assets. When the local currency appreciates, those liabilities get more expensive to settle in the parent's currency.

What are the key differences between the current rate and temporal methods?

• COGS & D&A: Current rate uses average rate (reflects currency moves). Temporal uses historical rate (ignores currency moves).

• Translation gain/loss: Current rate → loss when currency depreciates (net asset exposure). Temporal → gain when currency depreciates (net monetary liability exposure). They can have opposite signs.

• Where gain/loss goes: Current rate → equity (CTA). Temporal → income statement (more volatile net income).

• Assets: Current rate translates inventory and fixed assets at current rate (reflects depreciation). Temporal uses historical rate (does not).

Why do "pure" balance sheet and "pure" income statement ratios stay the same under the current rate method?

Because both the numerator and denominator get multiplied by the same exchange rate, so it cancels out and the ratio is unchanged.

: Under the current rate method, what happens to mixed ratios (income statement numerator, end-of-period balance sheet denominator) when the foreign currency is depreciating vs. appreciating?

Depreciating → translated ratio is larger (average rate > ending rate, so numerator is translated at a higher rate than denominator). Appreciating → translated ratio is smaller. Pure ratios are always unchanged.

Why is analyzing foreign currency exposure difficult for multinationals?

CTA, remeasurement G/L, and ratio effects are aggregated across all subsidiaries. Disclosure is limited — sometimes can't even tell which translation method is used. What's available is in footnotes and MD&A.

What comparability problem arises from functional currency judgment?

Two firms in the same industry may use different methods → temporal runs G/L through net income; current rate parks it in OCI → ratios not directly comparable.

What is the clean-surplus solution?

Add the change in CTA to net income to bring translation G/L into income. Apply the same logic to all non-owner equity changes (e.g., FVOCI unrealized G/L). Improves comparability but doesn't fully resolve all differences.

What are the 3 key ways financial institutions differ from other companies?

• Systemic importance — interconnected, contagion risk, subject to bank runs, deposits often government-insured

• Heavily regulated — minimum capital/liquidity requirements, limits on risk-taking

• Asset composition — primarily financial assets (loans, securities) at fair value, vs. tangible assets at depreciated historical cost for normal companies

What are the 3 pillars of Basel III?

• Minimum capital — required capital scales with asset risk; riskier assets = higher capital requirement

• Liquidity — must hold enough liquid assets to survive a 30-day stress scenario

• Stable funding — must have stable funding relative to liquidity needs over a 1-year horizon; longer-term and consumer deposits = more stable

Financial Stability Board

Coordinates actions across jurisdictions to identify and manage systemic risks

International Association of Deposit Insurers

Improves the effectiveness of deposit insurance systems

International Organization of Securities Commissions (IOSCO)

Promotes fair and efficient securities markets

International Association of Insurance Supervisors (IAIS)

Improves supervision of the insurance industry

What are the 3 Basel III minimum capital ratios?

• Common Equity Tier 1 ≥ 4.5% of RWA

• Total Tier 1 ≥ 6% of RWA

• Total Capital ≥ 8% of RWA

What's in each tier of bank capital?

• CET1 — common stock, APIC, retained earnings, OCI; minus intangibles and deferred tax assets

• Other Tier 1 — subordinated instruments, no maturity, no contractual dividends (e.g. preferred stock)

• Tier 2 — subordinated debt with original maturity >5 years

What are risk-weighted assets (RWA) and why do they matter?

Loans (largest, carried at amortized cost net of allowances) and investment securities (accounting treatment varies by classification under GAAP/IFRS)

When evaluating a bank's loan portfolio over time, what signals deteriorating asset quality?

Rising proportion of loans in sub-standard, past due, impaired, or seriously impaired categories — and declining proportion in strong/satisfactory categories

What are the 3 key loan loss ratios and what do they measure?

• Allowance / Non-performing loans — is the reserve big enough relative to bad loans?

• Allowance / Net charge-offs — how many years of actual losses does the reserve cover?

• Provision / Net charge-offs — is the current year's expense keeping up with actual losses? Below 1.0x = aggressive accounting

What does it signal if the provision for loan losses / net charge-offs ratio is below 1.0 and declining?

The bank is recording less expense than its actual losses — aggressive accounting, likely understating credit risk and overstating earnings

CAMELS Management

• Identify all the different types of risk the bank faces

• Control those risks and set limits on how much risk is acceptable

• Prevent managers from taking excessive or self-serving risks

What are the 3 major sources of bank earnings, and which is most volatile?

• Net interest income — spread between interest earned on loans/securities and interest paid on deposits

• Service income — fees, commissions

• Trading income — most volatile year-to-year

Banks with higher net interest income and service income have more sustainable earnings.

What are the 3 levels of the fair value hierarchy?

• Level 1 — quoted market prices of identical assets (most objective)

• Level 2 — observable but not direct quotes; e.g. similar assets, non-active market prices, observable rates/spreads

• Level 3 — non-observable, subjective; model-based or estimated cash flows (most prone to manipulation)

What makes bank earnings "high quality"?

Adequate (return above cost of capital), sustainable, positive trend, unbiased accounting estimates, and derived from recurring sources

What are the two Basel III liquidity standards and their minimums?

• LCR (Liquidity Coverage Ratio) = Highly liquid assets / Expected cash outflows over 30 days → minimum 100%

• NSFR (Net Stable Funding Ratio) = Available stable funding / Required stable funding → minimum 100%

What's the difference between what LCR and NSFR are measuring?

• LCR = short-term survival — can the bank survive a 30-day stress scenario?

• NSFR = long-term stability — does the bank have enough stable funding relative to its asset base over a 1-year horizon?

What do the ASF factors tell you, and what's the pattern?

ASF factors measure how "stable" each funding source is. The pattern:

• 100% — long-term capital (>1 year) and Tier 1 capital; most stable

• 95% — stable retail/small business deposits; sticky and unlikely to flee

• 90% — less-stable retail deposits; still fairly reliable

• 50% — corporate and government deposits <1 year; less reliable

• 0% — everything else; treated as unreliable

Longer maturity and retail/small business sources = more stable = higher ASF factor

What are concentration of funding and maturity mismatch, and why do they matter?

• Concentration of funding — relying on few funding sources; if those sources pull out, the bank faces a liquidity crunch

• Maturity mismatch — assets have longer maturities than liabilities (e.g. borrowing short, lending long); if the bank can't roll over short-term borrowings, it's stuck with illiquid long-term assets

Both increase liquidity risk

What is interest rate risk for a bank and what drives it?

The risk that changes in interest rates affect net interest income — driven by differences in maturity, rates, and repricing frequency between assets and liabilities.

Key example: if assets reprice faster than liabilities in a rising rate environment → net interest income increases (assets earn more before liabilities cost more)

What are the 3 keys to P&C insurer profitability?

• Prudent underwriting — only taking on risks worth bearing

• Adequate premium pricing — charging enough to cover expected losses

• Diversification of risk — including reinsurance to spread exposure

What are the three main mechanisms to misstate profitability?

(1) Aggressive revenue recognition — channel stuffing, bill-and-hold, fake sales. (2) Lessor finance lease classification. (3) Misclassifying operating vs. non-operating items, and channeling gains through NI / losses through OCI.

What are the key warning signs of misstated profitability?

Revenue growth above peers; receivables growing faster than revenue; high Q4 revenue concentration; unexplained operating margin boost; CFO below operating income; aggressive assumptions (e.g., long useful lives); pay tied to financial results.

What are the main mechanisms to misstate assets/liabilities?

Inappropriate valuation model inputs (e.g., inflated useful lives); reclassifying current assets as non-current; over/understating allowances and reserves; understating identifiable assets in acquisitions (inflating goodwill).

What are the key warning signs of misstated assets/liabilities?

Inconsistent valuation inputs; current assets classified as non-current; allowances that differ from peers or fluctuate; high goodwill to total assets; use of SPEs; large deferred tax swings; large off-balance-sheet liabilities.

What are the mechanisms and warning signs for overstated operating cash flows?

Mechanisms: stretching payables; misclassifying capex as operating. Warning signs: rising payables with falling inventory/receivables; high capitalised expenditures; increases in bank overdraft.

What are the incentives to manipulate financials around acquisitions?

Declining CFO firms acquire cash generators to boost operating cash flow. Stock deal acquirers inflate their stock price to use as currency; targets inflate to fetch a higher price. Some acquirers pursue deals specifically to obscure pre-existing accounting fraud.

How is goodwill manipulated at acquisition and why does it matter?

Acquirers understate identifiable assets (which get depreciated) and overstate goodwill (which isn't amortised), inflating future profits. The overstatement eventually unwinds via impairment, but charges can be timed and dismissed as non-recurring.

What is the Beneish M-Score and what does it signal?

A probit regression model using 8 variables to estimate the probability of earnings manipulation. M-Score > –1.78 indicates a higher-than-acceptable probability of manipulation.

Why do SGAI and LEVI have negative coefficients, and what did Beneish do about it?

Beneish expected positive coefficients (more leverage/overhead = more manipulation pressure), but the regression produced negative values. He later created an alternate model excluding both variables.

What are sustainable (persistent) earnings, and what makes earnings non-sustainable?

Sustainable earnings are those expected to recur in future periods. Earnings dominated by non-recurring items are non-sustainable and considered low quality. Classification of items as non-recurring is subjective and open to gaming — companies may shift normal operating expenses into "discontinued operations" or use pro forma metrics to make core earnings appear higher than they are. Analysts should scrutinize reconciliations between pro forma and reported income to assess whether excluded items are truly non-recurring.

How is earnings persistence measured, and why are accruals less persistent than cash flows?

Persistence is measured via regression: earnings(t+1) = α + β₁ earnings(t) + ε — a higher β₁ means more persistent earnings. Earnings can be split into cash and accrual components: earnings(t+1) = α + β₁ cash flow(t) + β₂ accruals(t) + ε, where β₁ > β₂, confirming cash flows are more persistent. Accruals require subjective estimates and judgments, making them easier to manipulate and less reliable as a predictor of future earnings. A major red flag: positive net income alongside negative operating cash flow.

What is the difference between discretionary and non-discretionary accruals, and what are external indicators of low earnings quality?

Non-discretionary accruals arise from normal business activity (e.g., credit sales growth, depreciation on assets). Discretionary accruals stem from abnormal transactions or accounting choices and are often used to manipulate earnings. They can be isolated by regressing total accruals on factors driving normal accruals — the residuals proxy for discretionary accruals. Other red flags include companies that repeatedly meet or barely beat consensus estimates. External indicators — SEC enforcement actions and restatements — signal low quality but are not useful for forecasting problems before they become public.