FSA - CFA Level 2

Intercorporate investment types

1. Investments in financial assets (investing firm has no significant control over the operations of the investee firm) - less than 20% ownership

2. Investments in associates (significant influence, no control) - between 20% to 50% ownership

3. Business combinations (control) - above 50% ownership

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

Accounting treatment of different ownerships

1. Less than 20% / Financial assets

   Amortized cost method, FVOCI, FVPL

2. 20%-50% / Associates

   Equity method

3. More than 50% / Business combinations

   Aquisition method

Terminologies

IFRS:

Amortized cost, FVPL, FVOCT

US GAAP:

Held-to-maturity, held for trading, available for sale

Amortized cost is ONLY for debt securities, upon meeting two conditions:

1. Business model test: debt securities are being held to collect contractual cash flows.

2. Cash flow characteristic test: The contractual cash flows are either principal, or interest on principal, only.

Steps of Equity Method (this is for investment in Associates)

1. The initial investment (amount you paid) is recorded at cost and reported on the balance sheet as a noncurrent asset.

2. In subsequent periods, the proportionate share of associate earnings increases the investment asset (on BS) and proportionate share of dividends paid reduces the investment account (on BS) as dividends are treated as a return of capital, not return on capital, thus reducing total investment value.

3. How does it look like on income statement? proportionate share of earnings is reported in the investor’s income statement. Dividends received are NOT report on income statement.

4. If the investee reports a loss, the proportionate share of the loss reduces the investment account and lowers earnings in the investor income statement.

5. If the losses reduce the investment account to zero, the equity method will be discontinued until the earnings exceed the share of losses that were not recognized during the suspension period.

Within Equity Method / Associates

Sometimes, you pay an excess purchase prices over book value acquired

• First the excess amount is allocated to identifiable assets and liabilities based on their fair values. If there is still excess remaining, it is allocated to Goodwill.

• In subsequent periods, the investor might recognize additional depreciation expense as a result of the fair value allocation of the purchase price to the investor’s fixed assets.

Impairment of Investments in Associates

• Equity method investments must be tested for impairment.

• Under US GAAP, if the fair value of the investment falls below the carrying value (investment account on the balance sheet) and the decline is considered permanent, the investment is written-down to fair value and a loss is recognized on the income statement.

• Under IFRS, impairment needs to be evidenced by one or more loss events.

• Under both IFRS and US GAAP, if there is a recovery in value in the future, the asset cannot be written-up.

Intercompany Transactions with the Associate

• If there is an upstream sale (investee to investor) or downstream (investor to investee), the investor must reduce the proportionate share of the unconfirmed profit from their profit, whether the unconfirmed profit is sitting in their inventory or their associate inventory. The associate, however, will record the full profit regardless of what happens after.

Acquisition method (how it differs from Equity method)

• Under the acquisition method, all of the assets, liabilities, revenues, and expenses of the subsidiary are combined with the parent. Intercompany transactions are excluded.

• In the case where the parent owns less than 100% of the subsidiary, it is necessary to create a noncontrolling (minority) interest account for the proportionate share of the subsidiary’s net assets that are not owned by the parent.

Business Combinations

Under IFRS, business combinations are not differentiated. Under US GAAP, business combinations can be categorized as:

1. Merger: the acquiring firm absorbs all assets and is the surviving entity.

2. Acquisition: both entities continue to exist in a parent-subsidiary relationship. Unowned (minority or noncontrolling) interest is reported on financial statements as well.

3. Consolidation: a new entity is formed that absorbs both of the combining entities.

How to treat business combinations? Aquisition method

Historically, there were two methods:

1. Purchase method

2. Pooling-of-interests methods

Now, pooling-of-interest has been eliminated and only the Acquisition method remains to replace the purchase method.

Pooling-of-interests method (aka Uniting-of-interests method)

Under IFRS, this method used to combine the ownership of two firms and viewed the participants as equal - neither firm acquired the other, just a combination of assets and liabilities. It also used historical book values in the combination, and operating results for prior periods were restated as though the two firms were always combined.

Acquisition method step

1. In an Acquistion, the assets and liabilities of both firms are combined, and the shareholder’s equity for the acquired firm is ignored (it’s not transferred to the acquiring entity, that is because this money is already paid out to buy the firm from the sellers)

2. However, within shareholder’s equity, create an account to put the minority interest (share that you don’t own)

3. In the income statement, revenues and expenses are combined, then minority interest (share of profit you don’t own) is deducted to arrive at Net income

4. The acquisition method results in higher revenues and expenses as compared with Equity method, but net income is the same.

Goodwill in Business Combinations

Under the Acquistion method, the purchase price is allocated to the identifiable assets and liabilities of the acquired firm on the basis of fair value. Any remainder is reported on the balance sheet as goodwill.

Full Goodwill vs Partial Goodwill

Under US GAAP (only Full Goodwill)

Goodwill is the amount by which the fair value of the subsidiary is greater than the fair value of the subsidiary’s net identifiable assets.

Full goodwill = (purchase price / % owned) - (fair value of net identifiable assets)

Under IFRS (Partial Goodwill)

Goodwill is the amount by which the purchase price of the subsidiary is greater than the proportion of the acquired company’s net identifiable assets.

IFRS also permits full goodwill.

Partial goodwill = purchase price - ( % owned x fair value of net identifiable assets)

Or

Partial goodwill = % owned x Full goodwill

Now that we have established that Full Goodwill is higher than partial, which results in higher total assets. How does that balance in the liabilities-and-equity side?

Well, minority interest (in equity) will be higher in Full goodwill, which will offset the different with Partial goodwill on the asset side, as minority interest is deducted.

Noncontrolling interest (full goodwill) = % not owned x (purchase price / % owned)

Noncontrolling interest (partial goodwill) = % not owned x (fair value of net identifiable assets of the subsidiary)

To know: full good will results in higher total assets and higher total equity, so ROA and ROE metrics will be lower with full goodwill

Bargain purchase

In rare cases, acquisition purchase price is less than the fair value of net assets acquired. Both IFRS and US GAAP require that the difference between fair value of net assets and purchase price be recognized as a gain in the income statement.

Joint Ventures

A joint venture is an entity in which control is shared by two or more investors.

Both IFRS and US GAAP require Equity method accounting (similar to associates - one line)

But, in rare cases, proportionate consolidation method is allowed.

Proportionate consolidation method is similar to a business acquisition, except the investor (venturer) only reports the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture.

Since only the proportionate share is reported, no minority owner’s interest is necessary.

Proportionate consolidation results in higher assets and liabilities compared to equity method, but stockholder’s equity (net assets) is the same.

Special Purpose Entity (SPE)

An SPE is a legal structure created to isolate certain assets and liabilities of the sponsor. An SPE can take the form of a corporation, partnership, joint venture, or trust.

The typical motivation is to reduce risk and thereby lower the cost of financing. SPEs are structured such that the sponsor company has control over the SPE’s finances or operating activities while third parties have controlling interest in the SPE’s equity.

Variable Interest Entity (VIE)

Is a special purpose entity that meets certain conditions. A VIE is an entity that has one or both of the following characteristics:

1. At-risk equity that is insufficient to finance the entity’s activities without additional financial support.

2. Equity investors that lack any of the following:

   • Decision making rights

   • The obligation to absorb expected losses

   • The right to receive expected residual returns

If an SPE is considered a VIE, it must be consolidated by the primary beneficiary. The primary beneficiary is the entity that absorbs the majority of the risks or receives majority of the rewards.

Contingent Assets and Liabilities

Under IFRS, only contingent liabilities whose fair value can be measured reliably are recognized at the time of acquisition (Contingent assets are never recognized).

In-process R&D

is capitalized as an intangible asset and included as an asset in both IFRS and US GAAP

Restructuring costs

are expensed when incurred, and not capitalized as part of the Acquistion cost in both IFRS and US GAAP

Analyse how different methods used to account for Intercorporate investments affect financial statements and ratios

1. All three methods report same net income

2. Equity method and proportionate consolidation report the same equity. Acquisition method equity will be higher by the amount of minority interest

3. Assets and liabilities are highest under the Acquistion method and lowest under the equity method; proportionate consolidation is in-between

4. Revenues and expenses are highest under the Acquistion method and lowest under the equity method; proportionate consolidation is in-between

For ratios

Net profit margin, ROE, ROA

Equity method is higher

Acquistion method is lower

Proportionate is in between except ROE is same as equity method

NEW READING: EMPLOYEE COMPENSATION & PENSION

Contrast types of employee compensation

• Short-term (less than 12 months): salaries, wages, bonus, health insurance, company match in defined contribution plans, and paid leave.

• Long-term (greater than 12 months): Long-term disability and long-term paid leave.

• Stock-based: options or stock grants.

• Post-retirement: defined benefit pensions and health care.

Vesting Period

Employees earn their compensation at the end of a vesting period.

This is typically a couple of weeks for salaries or wages, but several years for stock and option grants.

At the end of the vesting period, the compensation is settled (either by payment in cash or issuance of stock) on the settlement date.

Share-based compensation plans (usually offered to managers) can take two forms, stock options or stock grants

• For stock options, the asymmetric (upside only) payoff of stock options may incentivize managers to take too much risk. Even then, manager actions may have limited influence on market price.

• For stock grants, it may excessively managers’ personal wealth to that of the company (along with their existing employment) and therefore may motivate them to take a less-than-optimal amount of risk.

Explain how share-based compensation affects the financial statements

Let’s start with Stock Options

• First of all, share-based compensation is treated as an expense even though cash does not change hands.

• Compensation expense is based on the fair value of the options on the grant date

• The compensation expense is then allocated straight line (amortized in equal instalments) to the income statement over the vesting period, which is the time between the grant date and the vesting date.

• This compensation expense will decrease net income and retained earnings, and the offsetting entry is to increase the share-based compensation reserve (which is part of equity). Thus, retained earnings and compensation reserve off-set each other, there is no change in total equity.

• The hard part is actually to determine the fair value of the stock options. If the options are traded, you can use the observable market price of the option or a similar option.

• If not, you have to determine the option value using an option-pricing model, such as Black-Scholes.

• Note that fair value is only estimated on the grant date; subsequent changes in fair value are not considered.

• In order to arrive at a fair value valuation, you need to have some assumptions, and companies are required to disclose all these assumptions.

• Some assumptions are observable, such as grant date, stock price, maturity, exercise price, and the risk-free rate.

• Other assumptions are subjective, such as future stock price volatility.

• Companies often use implied volatilities based on other market-traded options on the company stock or based on historical volatility.

• If a lower estimate of future volatility is used, the value of the options will be underestimated, hence, the compensation expense will be underestimated, and reported earnings will be higher.

• Employees will exercise options only when they are in-the-money, and those employees that leave before the options vest forfeit their grant.

Explain how share-based compensation affects the financial statements

Now, let turn to Stock Grants

Stock or option grants often have specific conditions that need to be met for the grants to vest.

• Restricted stock grants have requirements that must be met before the option can be sold.

• A service condition is the most common restriction; this simply specifies the number of years of employment required before the options or stocks vest.

• Under a performance condition, the grant vests upon achievement of a specific target (EPS exceeds some amount) or a market condition where the target is based on a market metric (stock price).

• Performance-based restricted stocks are called performance shares.

• Restricted Stock Units (RSUs) are similar to performance shares, but instead of receiving shares upfront, RSUs are exchanged for stock when they vest. (Note that employees receiving RSU don’t accrue any dividends during the vesting period).

• RSUs are preferred over stock options by employees because they accrue some value if the stock price is above zero, are simpler for individual tax calculations, and have no exercise price outlays.

• Ok, now, estimating the fair value?

• The value of the stock grant is simply the value of the stock on the grant date times the number of shares granted. For RSU, the stock price is reduced by the estimated present value of the dividends expected during the vesting period. The total value is expensed over the vesting period and taken to equity as part of share-based compensation reserve.

• Upon settlement, the value of the stock is transferred out of the share-based compensation reserve and then allocated to common stock and paid-in capital.

• For option grants, upon exercise, there is a cash outflow from the strike price that is reported as financing activity in the cash flow statement. This exercise amount, along with the amount in the compensation reserve account, is then allocated to common stock / paid-in capital. If the options expire out-of-the-money, there is no further accounting treatment.

Disclosures required for share-based compensation

IFRS requires the following disclosures:

• The nature and extent of the compensation arrangement

• How the fair value was determined

• The arrangement’s impact on earnings

Post-employment benefits: Pension

A pension is a form of deferred compensation earned over time through employee service.

The most common pension arrangements are:

1. Defined-contribution plan

2. Defined-benefit plan

Defined-contribution plan

is a retirement plan whereby the firm contributes a certain sum each period to the employee’s retirement account.

• The firm’s contribution amount can be based on the years of service, employee age, compensation, profitability, or even a percentage of the employee’s contribution.

• In any event, the firm makes no promise to the employee regarding the future value of the plan assets.

• The investment decisions are left to the employee, who assumes all of the investment risk.

• Accounting for this is simple. The pension expense is simply equal to the employer’s contribution, and nothing is reported on the balance sheet.

Defined-benefit plan

In this, the firm promises to make a lump sum or periodic payment to the employee after retirement.

• This periodic payment is usually based on the employee’s years of service and the employee’s compensation after retirement.

• Because the employee’s future benefit is predetermined, it is the employer that assumes the investment risk.

• Accounting for this is more complicated; the firm must estimate the value of its future obligations. This involves forecasting a number of variables such as future compensation levels, employee turnover, retirement age, mortality rates, as well as choosing an appropriate discount rate.

• A company that offers defined benefits typically fund the plan by contributing assets to a separate legal entity, usually a trust. The plan assets are managed to generate the income and principal growth necessary to pay the pension benefits as they come due.

Funded status of the plan

Funded status of the plan is the difference between the benefit obligation and the plan assets.

• If the plan assets exceed the pension obligation, the plan is said to be ‘‘overfunded’’. Conversely, underfunded.

Now, let’s look at how the Balance Sheet is impact

Projected Benefit Obligation (PBO)

The projected benefit obligation (PBO) is the actuarial present value (at an assumed discount rate) of all future pension benefits earned to date, based on expected future salary increases.

• It measures the value of the obligation, assuming the firm is a going concern and that the employees will continue to work for the firm until they retire

• The discount rate used for PV computation is typically the yield on investment-grade corporate bonds

The funded status reflects the economic standing of the pension plan

Funded status = fair value of plan assets - PBO

Balance sheet presentation under both US GAAP and IFRS

Balance sheet asset (liability) = funded status

If the funded asset is negative, it is reported as a liability. If it is positive, it is reported as an asset

Interest Cost under US GAAP

Interest cost = [beginning PBO + past service cost] x discount rate

Interest Cost under IFRS

Interest cost = [beginning funded status - past service cost] x discount rate

Disclosures under IFRS

Plans are required to:

• Disclose the main characteristic of the plan and the risks involved

• Identify and explain the figures in the financial statements arising from them

• Describe the amount, timing, and uncertainty of future cash flows

To know

Service cost is an operating expense, representing the increase in the benefit obligation from current and past service. Net interest expense/income is financing expense/income recognized below the operating income line. Remeasurements are recognized in OCI, not in earnings.