fra cfa level 2

8/12/2019 FRA CFA Level 2

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Capitalized interest Intercorporate investments

Employee compensation: post-employee and sharebased

Multinational operations


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When a firm constructs an asset for its own use or, in limitedcircumstances, for resale, the interest that accrues during theconstruction period is capitalized as a part of the assetscost. Theobjective of capitalizing interest is to accurately measure the cost ofthe asset & to better match the cost with the revenues generated bythe constructed asset. The treatment of capitalizing interest is similarunder US GAAP & IFRS.

The interest rate used to capitalize interest is based on debtspecifically related to the construction of the asset. IF no constructiondebt is outstanding, the interest rate is based on existing unrelatedborrowing. Interest costs on general corporate debt is excess ofproject construction costs are expensed.

Capitalized interest is not respond in the income statement asinterest expense. Once construction interest is capitalized, theinterest cost is allocated to the income statement throughdepreciation expense (if the asset is held for use), or COGS (if theasset is held for sale).

Generally, capitalized interest is reported in the cash flow statementas an outflow from investing activities, while interest expense is

reported as an outflow from operating activities.


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Securities that are purchased by corporations rather thanindividual investors. Intercorporate investments allow acompany to achieve higher growth rates compared to keepingall of its funds in cash. These investments can also be usedfor strategic purposes like forming a joint ventures or making

acquisitions. Companies purchase securities from othercompanies, banks and governments in order to takeadvantage of the returns from these securities. Marketablesecurities that can readily be exchanged for cash, such asnotes and stocks, are usually preferred for this type ofinvestment.

Intercorporate investments are accounted for differently thanother funds held by a company. Short-term investments thatare expected to be turned into cash are considered currentassets, while other investments are considered non-currentassets. When companies buy intercorporate investments,dividend and interest revenue is reported on the income

statement.


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Financial assets - an ownership interest of lessthan 20% is considered as passive investment .There 3 types of financial assets under IFRS &US GAAP

1. Held to maturity - are debt securities acquiredwith the intent & ability to be held to maturity .

2. Held for tradingare debt & equity securities forthe purpose of profiting in the near term .

3. Available for saleare debt & equity securitiesthat neither held to maturity nor held for trading .


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Investments in associatesownership interestbetween 20% & 50% is typically a non controllinginvestment . The investor can usually significantlyinfluence the investees business operations .

Business combinationsownership interest ofmore than 50% is usually a controlling investment .

Joint venturesis a entity where control is shared

by 2 or more investors.


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Under US GAAP , a security is considered impaired if its decline in

value is determined to be other than temporary.

Under IFRS impairment of a debt security is indicated if at least one

loss event has occurred and its effect on the securitys future cash

flow can be estimated .

An equity security can be considered impaired if its fair value has

experienced a substantial or extended decline below its carrying

value . Held to maturity become impaired when its carrying value is

decreased to the present value of its estimated future cash flows.

Under IFRS , impairments of available for sale debt securities may

be reversed under the sane conditions as impairments of held tomaturity securities . Reversals of impairments are not permitted for

equity securities . Under US GAAP , impairments on available for

sale may not be reversed for either debt or equity. Impairment of held

for trading securities are not allowed under US GAAP & IFRS


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Held-to-Maturity Held-for-Trading Available-for-

sale

Balance Sheet Amortized cost Fair value Fair Value with

unrealized G/L

recognized in

equity

Income Statement Interest (including

amortization)

Realized G/L

Interest Dividends

Realized G/L

Unrealized G/L

Interest Dividends

Realized G/L


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Investment ownership of between 20% & 50% is considered

investment in associates . Equity method is used for reporting

Equity method

Income statement treatment

Proportionate share of investee earnings is recognized

Additional, depreciation from excess of purchase price allocated to

investee assets & liabilities

Balance sheet treatment Proportionate share of investee earnings increases investment

account

Dividends decreases investment account

Equity income from income statement increases investment

account


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At the acquisition date, the excess of the purchaseprice over the proportionate share of the investeesbook value is allocated to the investeesidentifiable assets & liabilities based on their fair

values . Any remainder is considered as goodwill .

Impairment of investment of associates

If the fair value of the investment fall below the

carrying value . The investment is written down tofair value & loss is recognized in the incomestatement


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Under IFRS, business combinations are not differentiated based on thestructure of the surviving entity. Under US GAAP, business combinations arecategorized as:

Merger - The combining of two or more companies, generally by offering thestockholders of one company securities in the acquiring company inexchange for the surrender of their stock.

Acquisition- A corporate action in which a company buys most, if not all, ofthe target company's ownership stakes in order to assume control of thetarget firm. Acquisitions are often made as part of a company's growthstrategy whereby it is more beneficial to take over an existing firm'soperations and niche compared to expanding on its own. Acquisitions areoften paid in cash, the acquiring company's stock or a combination of both.

Consolidation - A stage in the life of a company or an industry in whichcomponents in the company or industry start to merge to form fewer

components. These components can include product lines at the companylevel or companies themselves at the industry level. The consolidation ofcompanies differs from mergers in that consolidations create new entitieswhile mergers do not.

Special Purpose Entities It is a legal entity created to fulfill narrow,specific or temporary objectives. SPEs are typically used by companies toisolate the firm from financial risk.


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There are 2 approaches for accounting

Pooling of interest method (or uniting of interestunder IFRS)

Purchase method (acquisition method)acquisition methodthree major accounting issues .

1. Recognition and measurement of assets andliabilities of the combined entities

2. Goodwill : initial recognition & subsequent treatment3. Minority interest : recognition and measurement of

non controlling interest


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Identifiable assets and liabilities

To be measured at the fair value on the date of acquisition

Contingent liabilities

The parent must recognize any contingent liabilities whichcan create an obligation due to past action of the subsidiary .

Financial assets

Reclassification can be done by the parent at the time of

acquisition

Goodwill is equal to the excess of purchase consideration paid

over the fair value of identifiable net assets acquired


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Add each asset and liability of the subsidiary (100%) with the parent

company

Dont add equity accounts

Remove the investments in shares of subsidiary from parents

B/sheet

Remove all inter company balances

Equity of subsidiary doesnt figure into parents balance sheet

SBI SBH

Owns 100%SBH is a wholly owned

subsidiary of SBI


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There are two methods of recognizing goodwill at the time ofacquisition

Full goodwill method (compulsory under US GAAP) Partial goodwill method ( preferred under IFRS)

1. Full goodwill methodgoodwill = fair value of the subsidiaryfair value oftotal identifiable net assets.

1. Partial goodwill methodgoodwill = acquisition pricefair valueproportionate identifiable net assets .


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Add each line item of subsidiary (100%) with the parent company .Dont add equity accounts

Remove the investments in shares of subsidiary from parents

B/sheet

Remove all inter company balances

Equity of subsidiary does not figure into parents balance sheet Minority interest is share of the other investors in the net assets of

the subsidiary and shown in equity

SBI

SBH

Owns 60%

HDFC will be called as minority

Interest in the books of SBI when it

consolidates the books of SBH

SBH Owns 40%


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Value of minority interest depends upon

the method of recognizing goodwill

1. Full goodwill method

MI = shareholding% x fair value of

subsidiary

1. Partial goodwill methodMI = share holdings x fair value of net

assets of subsidiary


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Steps

Add each line of subsidiary (100%) with the parent company

Remove all; inter company transactions

Arrive at the consolidated profit before minority interest Subtract minority interest after calculating PAT

Notes

If the subsidiary has incurred profits >>the value of its equitygoes up>> value of minority interest will also go up

Value of consolidated income is not dependent of the method

of goodwill valuation


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Important points Goodwill to be recognized only when purchased Goodwill is neither depreciated nor amortized Goodwill is tested for impairment at least annuallyImpairment (US GAAP)

1. Recoverability testwhether to impair?Goodwill to be impaired when net book value of reporting unit > FVof reporting unit

2. Loss impairmenthow much to impair?Impairment loss = Book value of goodwill (less)Implied fair value

of goodwill

Under IFRS

Impairment loss = Book value of cash generating unitfair valueof cash generating unit


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SPE is an legal structure created tom isolate certainliabilities from the main company . It is created by theprimary sponsor and finances its activities .

It can take following forms : corporation, joint venture

or trust VIE is a category of SPE that meets any or both of the

following conditions :1. Risk-equity is insufficient to finance the entities

activities without additional financial support .2. Equity investors that lack anyone of the following . Decision making right Obligation to absorb expected loss Right to receive residual return


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Equity Method ProportionateConsolidation

AcquisitionMethod

Leverage LowerLiabilities

are lower & equity

is the same

In-between Higher

Net profitmargin

Higher-sales arelower & net income

is the same

In-between Lower

ROE Higher-equity is

lower & net incomeis the same

Same as Equity

Method

Lower

ROA Higher-net income

is the same &

assets are lower

In-between Lower


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Present value calculation need to be understood in

detailRule of pension accounting for income statement

and balance sheetRules of adjustment in US GAAP and IFRS need to

be differentiated


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Defined contribution plan

1. Firm make a periodic contribution to the retirement fund2. Based on factors like no of years service , last drawn salary , employee

age , profits etc3. No assurance by the firm for the final placement of the liability4. Fund managed by the employees5. No assurance by the firm for the future value plan assets6. Pension expense = contribution made each year7. No liability recognized on the balance sheet

Defined benefit plan

1. Firm makes a periodic contribution to the retirement fund2. Fund managed by the firm through an independent trust3. Payment to be made to each employee after the retirement till his / her

death4. Approximation of several factors involved to estimate the total pension

obligation5. Investment risk of fund assets lies with firm which has responsibility for the

discharge of the retirement obligation


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Balance sheet impact Assetsfair value of plan assets in pension fund Liabilitypresent value of amount owed to employee for their services till date ( define

benefit obligation)

Fund assets are compared against fund liabilities

In case the status is overvalued ( assets more than liabilities)- difference is shown on

assets side

In case the status is undervalued ( liability more than assets)- difference is shown on

liability side

Income statement impact : pension expense include the following Service costPV of benefits earned by employee due to their service in the current period

Interest costclosing PV of obligation estimated at beginning of year (less) opening PV of

obligation estimated at beginning of the year

Actuarial gain or lossPV of any change in future obligation caused because of changes in

assumptions used by actuarial

Prior service costretroactive benefits awarded to employees when a plan is initiated or

amended

Expected return on fund assetsit reduced the pension expense . Expected return is used

in price of actual return to reduce the volatility


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IT is the actuarial present value (at an assumeddiscount rate) of all future pension benefits earnedto date, based on expected future salaryincreases.

The assumptions here are of going concern andthat the employees will work until retirement .

It is the actuarial present value (at an assumeddiscount rate) of all future pension benefit earnedto date, based on current salary levels, ignoringfuture salary increases.

It is on current basis and shows the liability thatwill be payable if the firm expects to liquidate andsettle pension obligation.

This is the amt of ABO that is not contingent onfuture service. For example, the minimum tenureof the employee for being eligible to receivepension benefits.

Present value of Cash outflow required to satisfythe pension obligation (Less) Fair Value ofPension Plan assets.

Under US GAAP

Projected Benefit

Obligation (PBO)

Accumulated Benefit

Obligation (ABO)

Vested Benefit

Obligation (VBO)

Funded Status


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Opening Obligation

Current Service Cost

Interest Cost

Plan Amendments

Actuarial gains and losses

Benefit Paid

Closing Obligation


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It is the PV of benefits earned by theemployees during the current.

It is the increase in the PBO that is theresult of the employees working onemore period.

For PBO, it includes an estimate ofcompensation growth It is immediately recognized as a

component of pension expense .

Increase in the obligation due to passage

of time It is equal to beg. Pension obligation xdiscount rate

It is immediately recognized as acomponent of pension expense.

Current Service

Cost

Interest Cost


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It is the change in PBO as a result of the firm

adopting or amending its pension plan.

Charged immediately in Income Statement; or

Report in OCI and amortize over remaining

average service life

Gains and losses arising as a result of changes

in variables such as mortality, employee turnover,retirement age and the discount rate.

This also includes any difference between actual

and estimated return on plan assets.

Charged immediately in Income Statement; or

Report in OCI and follow Corridor method for

recognition

Pension paid to employees during the current

year.

It reduces the pension obligation (treat it like a

liability that has been paid)

Past (prior) ServiceCosts

Change in ActuarialAssumptions

Benefits Paid


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It is the interest rate used to calculate the PV of benefit

obligation

It affects all measures of benefit viz., ABO, PBO & VBO and

Pension expense.

It is not risk free rate. It is based on interest rates of high quality

fixed income investments with maturity profile similar to the

future obligation

It is the expected average annual rate of compensation increase. It affects PBO and Pension expense but has no impact on ABO

and VBO

It is the assumed long term rate of return on the investments in

the plan

Its treatment is similar to any other actuarial assumptions

Expected return on plan assets is recognized as part of pensionexpense (-ve)

Treatment of difference between Expected and Actual Return is

same as that of actuarial gains/losses. Such amount is clubbed

with Actuarial gains/losses and treated accordingly

Discount

(Settlement)Rate

Rate ofCompensation

growth

Expected

Return on planAssets


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Current Service Cost

Interest Cost

Expected Return on Assets

Amortization of Deferred (gains) and

Losses

Amortization of past service cost

Pension Expenses


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Used to recognized AGL that were taken to

OCI (and not to income statement)

Take the opening balance of PBO and FV of

plan assets

Take the one which is higher Take 10% of it

This is the corridor (max range available to

the company )

If the unrecognized AGL exceed this range ,

then this excess needs to be amortized

The amortized will be over expected average

remaining service lives of the employees

When It is Used ?

Treatment underCORRIDOR

METHOD


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PBO at beginning of period

Current service cost

Interest cost

Plan amendments

Actuarial (gains)/lossesBenefits paid

PBO at end of period

Fair value of plan assets at the BegActual return on assets

Employer contributions

Benefits paid

FV of plan assets at the end

Firms are required to disclose reconciliation of PBO and plan assets in the financial

footnotes

PBO

Plan Assets


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Effect on Increase Discount

Rate

Decrease Rate of

compensationIncrease

Increase Expected

Rate of Return

PBO Decrease Decrease No Effect

ABO Decrease No Effect No Effect

VBO Decrease No Effect No Effect

Effect of changing plan assumptions on Benefit Obligation


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Effect of changing plan assumptions on Pension Expenses

Effect on Increase Discount

Rate

Decrease Rate of

compensation

Increase

Increase Expected

Rate of Return

Service Cost Decrease Decrease No Effect

Interest Cost Decrease* Decrease No Effect

Expected Return No Effect No Effect Increase

Pension Expenses Decrease* Decrease Decrease

* For mature plans, a higher discount rate might increase interest

cost. In rate cases, interest cost will increase by enough to offset the

decrease in the service cost, and pension expenses will increase.


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All the actuarial gains or loss AND prior period costs needs tobe recognized as pension liability under the US GAAP

irrespective of the fact whether it has been expensed in

income statement or taken to OCI

That is, Under US GAAP the net pension asset or liability

reported on the balance sheet equals to the funded Pension Accounting under US GAAP does not reduce the

volatility of the FUNDED STATUS (by not eliminating past

service cost and deferred gains and losses that have not yet

been recognized in the income statement).

On the positive side: The net pension asset/liability reportedon the balance sheet represents the economic reality.

Reported Expense, however is still smoothed number that

may not represent economic reality and thus will require

adjustment for analytical purposes


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Adjustments required when transaction takes

place involving currency of two differentcountries

When assets and liabilities are in a currencyother than the reporting currency?


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Meaning: when a company make any operational transaction involvingcurrency of other country

Example: (1) A firm in the US has sold goods to a customer in Europe (2) A

firm in the US has purchased goods from a supplier in Japan

There is no legal entity in FC which need to be consolidated into HC

Since there is no equity investment involved, there is no need to

consolidate any FS

Impact on financial statement

Sales / purchase is initially recognized at the spot rate on the transaction

date.

Balance sheet values (Debtors / Creditors) are re-stated at the closing rate

any realized gain / loss is T/F Income Statement

At the time of payment, Debtors / Creditors are settled at the rate on the

date of cash flow and any gain / loss (from the previous balance sheet

value) is recognized in income statement

Rules of inter-corporate investments do not come into picture


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Currency of the investees country being referred to

Currency of the primary economic environment in which the

entity operates. Usually the currency of cash generation and

spending

Determined by the Management

As per IASB, the management should consider the following

factors while determining the functional currency:

Currency in which the parent company prepares its financial

statements

This is the main concept and the rules / standards learnt will be used to

convert a foreign currency FS into Home Currency

The currency that influences sale prices for goods and services

Currency of the country whose competitive forces and regulations

mainly determine the sale price of goods and services The currency that influences labor, material and other costs

The currency from which funds are generated

The currency in which receipts from operating activities are usually

retained

Local currency

Functional

Currency

Reporting

(Presentation

currency)


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The consolidation of the foreign subsidiary is similar to the

consolidation of a local subsidiary

There are two steps in converting foreign subsidiarys financial

statements:

Conversion from local currency to functional currency This is also called re-measurement

Temporal method is used

Re-measurement usually occurs when a subsidiary is well integrated

with the parent (i.e.; parent takes O,I&F decisions)

Conversion from functional currency to reporting currency This is also called translation Current rate method is used Translation usually involves self contained , independent,

subsidiaries whose operating , investing and financingactivities are decentralized from parent


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The current rateis the exchange rate on the balance sheet date .

The average rate is the average exchange rate over the reporting period

The historical rate is the actual rate that wads in effect when the original

transaction occurred. For example , if a firm bought machinery on January 2,

2008, the historical rate for that transaction at every balance sheet date in

the future would be the exchange rate on January 2, 2008 Remeasurement involves converting the local currency into functional

currency using the temporal method .

Translationinvolves converting the functional currency into the parents

presentation (reporting) currency using the current rate method. The current

rate method is also known as the all- current method

Monetary assets and liabilities are fixed in amount of currency to bereceived or paid and includes cash , receivables , payables and short term

and long term debt

All other assets and liabilities such as inventory , fixed assets unearned

revenue etc. are examples of non monetary assets

Clean surplus : taking any unrealized gain/loss into income statement

Dirty surplus : taking any unrealized gain/loss into OCI > equity


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Remeasurement Translation

Functional

Currency

Local

currency

Reporting

currency

Local

currency

Functional = Reporting

currency

Local = Functionalcurrency

Reportingcurrency


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1. Income statement is translated first at the average rate to calculate

the translated profit

2. The translated profit is then taken to the translated balance sheet

which has different assets and liabilities being translated as per table

below

3. The balancing difference in the balance sheet is the currencytranslation gain or loss which is part of OCI (and thus part of Equity)

Parameter Conversion Rate

All income statement A/cs Average Rate

All Balance sheet A/cs (except

common stock)

Current Rate

Common Stock Historical Rate (Date of issue of stock)

Dividends Rate at the time of payment (i.e., Historical

Rate)

Translation Gains / Losses Report under shareholders equity as CTA


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1. Balance sheet is remeasured first as per table below

2.

The net difference in the equity (closing less opening) is the remeasuredPAT during the year

3. Income statement is remeasured as per table below to calculate the PAT

4. Difference in PAT as per step 2 (from Balance sheet) and step 3 (from

Income statement) is the remeasurement gain / loss which has

automatically become part of the Income statement

Parameter Conversion Rate

Balance Sheet A/cs

Monetary Assets & Liabilities Current Rate

All other assets and liabilities i.e., Non Monetary

assets and liabilities

Historical Rate

Income statement A/cs

Expenses related to non monetary assets (Eg.

COGS, D&A)

Historical Rate

Revenues and all other expenses Average Rate

Remeasurement gains / losses Recognise in the income statement


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Current method Temporal method

Exposure is equal to net assets

position of the subsidiary

Exposure is equal to net monetary

assets or liability position

Generally net assets position is

positive

Generally firms have net monetary

liability position as only few assets are

considered monetary

If subsidiary has net assets exposure

and foreign currency is appreciating ,

a gain is recognized

If subsidiary has net monetary assets

exposure and foreign currency is

appreciating , a gain is recognized

Difficult to eliminate exposure by

managing the net assets as it would

result into elimination of share holders

equity

Firms can eliminate the exposure by

managing assets and liabilities


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Since inventory is a non monetary asset, itshould be re measured using the historic rate

FIFO ending inventory and LIFO COGS arere measured based on most exchange rates

FIFO COGS and LIFO ending inventory arere measured using older exchange rates

Under the weighted average method , endinginventory and COGS are re measured at the

weighted average exchange rate for theperiod


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Temporal method All current method

Monetary A&L Current rate Current rate

Non monetary A&L Historical Current rate

Common stock Historical historical

Equity (full) mixed Current rate

Revenue and SG&A Average rate Average rate

COGS Historical Average rate

D&A Historical Average rateNet income mixed Average rate

Exposure Net monetary assets Net assets

Forex gain or loss Income statement Equity (in oci)


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This is the comparison between the original FS in local currency and finally converted

FS in reporting this conversion would have involved either translated or remeasured or both

Current method pure ratios will not be affected

If foreign currency is depreciating , translated mixed ratio will be greater than the

original and vice versa .(assuming mixed ratio has income statement item in thenumerator and b/sheet item in denominator)

Temporal method depends on which item has been converted at what rate and what is the trend in

exchange rates

Pure ratios : both Nr and Dr from the same FAeither from income statementor from the balance sheet

E.g. current ratio, debt to equity , proprietary ratio(from BS), GP/NP margin ,(from

Inc St.)

Mixed ratio : both Nr and Dr are from different FAone from income statementAND one . From the balance sheet

E.g. ROCE, ROE , Turnover ratios


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Hyperinflation= cumulative inflation exceeds 100% over 3 years , defined by FASB(CAGR of over 26%)

IFRS: FS are restated for inflation and then translated using rules of current method non monetary A&L to be restated using price index change since acquisition

Not necessary to restate Monetary A&L

Components of equity (change in PI during the year or post contribution , if that is later )

Income statement items (change in PI from the date of transaction )

Net purchasing power gain/loss is recognized in the income statement (NOT OCI)

Balance sheet is closed first and the difference takes place in income statement

US GAAP : adjusting non monetary assets and liabilities for inflation is not allowed underUS GAAP

We assume that since LC has been severely depreciated , functional currency =

reporting currency

Remeasurement is donetemporal method is used

Value of local currency would have been severely depreciated (PP Theory)

thus converting the values into reporting currency without adjusting for inflation

will reduce their weight significantly in the reporting currency


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fra cfa level 2

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