Study session 6 in the Level II CFA Program curriculum continues Financial Reporting & Analysis with three readings (19-21) on intercorporate investments, multi-national operations, and post-employment and share-based compensation.
The accounting method used depends on the degree of influence and level of ownership.
Minority passive investments (no influence and <20% stake) are accounted for as held-for-trading, available for sale, or held-to-maturity investments. HTM securities are reported at amortized costs while trading and available securities are reported at fair value. Understand the accounting treatment for realized and unrealized gains or losses for each of the three classifications.
Minority active investments (significant influence and between 20% and 50% stake) are accounted for under the equity method. The equity method is carried on the balance sheet as the beginning investment plus/minus the share of the net income (also reported on income statement) and minus any dividends received. Understand the limitations of the equity method (i.e. distorted solvency and liquidity ratios and overstated profit margin).
Understand the difference between the two types of transactions with associates, upstream or downstream. Profits on upstream transactions are recorded on the associate’s income statement while profits on downstream transactions are recorded on the investor’s income statement. The investor’s share of unrealized profit is included as equity income for upstream transactions.
Ownership greater than 50% is accounted for under consolidated statements. You need to understand the difference between the methods of consolidation and how it affects the ratios.
** Understanding how the accounting methods affect financial statements and ratios will go a long way to understanding what is going on and why one method may be preferred. Under the equity method; total assets, liabilities, revenue, expenses and operating income are lower. These accounts would be higher under the acquisition method and in-between for proportionate consolidation. Leverage ratios will be higher for the acquisition method but net profit margin, ROE and ROA will all be lower compared to the equity method.
Retirement plans are a big part of both the CFA Level II and III curriculum. The details of plan accounting are important on the Level II exam while a more basic understanding of how plan needs affect investment decisions is important in the Level III CFA Program curriculum.
Be able to calculate pension expense, funded status, economic pension expense and the defined benefit obligation.
Pension expense = current service costs + interest costs – expected return on plan assets plus/minus amortization of past service costs or actuarial losses.
*Do not confuse the pension expense with the economic pension expense. The economic pension expense substitutes the expected return with the actual return on plan assets. If contributions during a period exceed the plan’s economic pension expense, the excess reduces the pension obligation and is reclassified from operating cash outflows to financing cash outflows.
Defined Benefit Obligation = beginning DBO + service cost + interest cost + past service costs from current period amendments plus/minus any actuarial changes incurred – benefits paid.
Beyond the accounting, you also need to interpret the effect of changing assumptions on the benefit obligations and pension expense.
A higher discount rate will lead to a lower pension obligation and lower pension costs as well as improving the funded status of the plan. It will decrease the current service cost, the interest cost and pension expense.
A higher rate of compensation growth will result in a higher pension obligation and higher costs. It will increase current service costs, interest cost and pension expense.
A higher expected rate of return on plan assets will have no effect on the pension obligation but lower pension costs under U.S. GAAP. It will decrease the pension expense but will have no effect on the current service cost or interest costs.
The material on share-based compensation is secondary to pensions and entirely conceptual. Understand the basic definitions, advantages and disadvantages.
This importance in this reading has become overwhelmingly clear last week as Venezuela decides to devalue its currency for the fifth time in nine years and analysts evaluate the affect on companies like Colgate-Palmolive and Avon.
First, understand the difference between the functional and presentation currency and which method to use for accounting. The functional currency is that where the economic activity is being generated, the sale. The presentation currency is that used in the company’s financial statements and the local currency is used to represent a foreign currency.
If the local currency is the same as the functional currency (and different from the presentation currency, then the All-current method is used. If the functional and presentation currency are the same, and different from the local currency, then use the temporal method.
One of the more difficult parts of the reading is remembering which exchange rate to use between the average, current and historical rates. Generally, the current method uses current rates except: Historical rates in equity and the average rate on all income statement items. The temporal method uses the average rate for revenues and most expenses but the historical rate for some expenses and a mixed rate on net income. The temporal method uses the current rate for liabilities (except those nonmonetary liabilities not measured at current values).
Half of the material covers the accounting practices and the other half is on analyzing the comparative effects on the financial statements. The best way to see this is just to build out a table with the relevant ratios down one side and the methods across the top.
Study session 7 concludes FRA with three readings on earnings quality issues and ratio analysis and is relatively easier than the prior two study sessions. You may want to review the key points in the FRA readings and do some practice problems each week to make sure you retain this very important topic.
‘til next time, happy studyin’
Joseph Hogue, CFA