CFA_L2_2024_Volume2

Financial
Statement Analysis
Learning Module 1
Intercorporate Investments
LOS: Describe the classification, measurement, and disclosure under International Financial
Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates,
3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities.
LOS: Compare and contrast IFRS and US GAAP in their classification, measurement, and
disclosure of investments in financial assets, investment in associates, joint ventures, business
combinations, and special purpose and variable interest entities.
LOS: Analyze how different methods used to account for intercorporate investments affect
financial statements and ratios.
Note: Candidates are expected to be familiar with the overall analytical framework as well as the alternative
accounting methods for financial analysis and valuation as provided in the assigned reading. Candidates
are not responsible for changes (new rulings and/or pronouncements) that occurred after the material
was written.
Basic Corporate Investment Categories
Over the last few years, IFRS and US GAAP have worked to reduce differences in accounting standards
that apply to the classification, measurement, and disclosure of intercorporate investments. The resulting
standards have improved the relevance, transparency, and comparability of information provided in financial
statements; however, some differences remain. The terminology used in this reading is based on IFRS. US
GAAP may not use identical terminology, but in most cases the terminology is similar.
Investments in marketable debt and equity securities can be categorized as:
y Investments in financial assets: The investor has no significant influence or control over the
operations of the investee. Generally, the investor holds less than 20% equity interest in the investee.
y Investments in associates: The investor can exert significant influence, but not control, over the
investee. Generally, the investor holds between 20% and 50% equity interest in the investee.
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Learning Module 1
y Business combinations (including investments in subsidiaries): The investor has control over the
investee. Generally, an equity interest exceeding 50% indicates this control.
y Joint ventures, in which control is shared by two or more entities.
Note that the classification of an investment is based on the degree of influence or control, not purely on the
holding percentages provided above.
Exhibit 1 Summary of accounting treatment for investments
In business
In financial assets In associates In joint ventures
combinations
Influence Not significant Significant Controlling Shared control
Typical
Usually
percentage Usually <20% Usually > 50% Varies
20% – 50%
interest
Classified as:
y Fair value through profit or
Financial loss IFRS: Equity
reporting Equity method Consolidation
y Fair value through other method
treatment
comprehensive income
y Amortized cost
Investments in Financial Assets: IFRS 9
Both the international (IASB) and United States (FASB) accounting standards boards have developed new
standards for financial investments.
y The IASB issued IFRS 9, Financial Instruments, which became effective on January 1, 2018.
y The FASB issued ASC 825 in January 2016, with the standard being effective for periods after
December 15, 2017. This standard is in significant (but not total) convergence with IFRS with respect
to financial instruments.
IFRS 9 is based on an approach that considers (1) the contractual characteristic of cash flows and (2)
the management of financial assets. The terms "available-for-sale" and "held-to-maturity" no longer
appear in IFRS 9.
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Another key change in IFRS 9, compared with the old standard IAS 39, relates to the approach to
provisioning models for financial assets, financial guarantees, loan commitments, and lease receivables.
That is, IFRS 9 uses an expected credit loss model and evaluates not only historical and current information
about loan performance, but also forward-looking information.
The criteria for using amortized cost are similar between the two standards. In order to be measured at
amortized cost, financial assets must meet:
y A business model test: The financial assets are being held to collect contractual cash flows.
y A cash flow characteristic test: The contractual cash flows are solely payments of principal and interest
on principal.
Classification and Measurement

IFRS 9 classifies all financial assets as reported at amortized cost or fair value. All financial assets are
measured at fair value when initially acquired. Subsequently, those assets are measured at either fair value
or amortized cost.
y Financial assets that meet the business model and cash flow characteristic tests are generally
measured at amortized cost.
y If a financial asset meets the two tests but may be sold (ie, a "hold to collect and sell" business model),
it may be measured at fair value through other comprehensive income (FVOCI).
y However, management may choose the fair value through profit or loss (FVPL) option to avoid an
accounting mismatch. An accounting mismatch refers to an inconsistency resulting from different
measurement bases for assets and liabilities.
Debt instruments are measured at amortized cost, FVOCI, or fair value through profit or loss (FVPL),
depending upon the business model.
Equity investments can be measured at either FVPL or FVOCI, but the choice is irreversible. If the entity
uses the FVOCI option, only the dividend income is recognized in profit or loss. Further, the requirements
for reclassifying gains or losses recognized in other comprehensive income are different for debt and equity
instruments.
Financial assets that are derivatives are measured at fair value through profit or loss (except for hedging
instruments). Embedded derivatives are not separated from the hybrid contract if the asset falls within the
scope of this standard and the asset as a whole is measured at FVPL.
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Learning Module 1
Exhibit 2 Financial valuation and reporting approaches for investments in financial assets
Type of security Debt Equity
• Held to collect
contractual cash flows?
No Yes Held for trading?
• Cash flows are solely
principal and interest?
Yes No
Classification Amortized cost Fair value Fair value

through profit through other
or loss comprehensive
income
Reclassification of Investments
Under the new standards:
y Reclassification is not permitted for equity instruments (ie, the initial classification of FVPL or FVOCI
is irrevocable).
y Debt instruments may be reclassified from FVPL to amortized cost (or vice versa) only if the objective
for holding the assets (ie, business model) has changed in a way that significantly affects operations.
When debt instrument reclassification is appropriate, there is no restatement of prior periods at the
reclassification date. If the financial asset is reclassified from:
○ amortized cost to FVPL, the asset is measured at fair value with gain or loss recognized in
profit or loss.
○ FVPL to amortized cost, the fair value at the reclassification date becomes the carrying amount.
Convergence between IFRS and US GAAP standards for the classification, measurement, and reporting of
investments in financial assets has made it easier for analysts to make comparisons across companies.
Analysts typically assess the performance of a company’s operating and investing activities separately.
Analysis of operating performance should exclude items related to investing activities (eg, interest income,
dividends, realized and unrealized gains/losses). Nonoperating assets should be excluded from the
calculation of return on operating assets. The use of financial assets’ market values is encouraged when
assessing performance ratios. Both IFRS and US GAAP require disclosure of the fair value of all classes of
financial assets.
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Investments in Associates and Joint Ventures
An investor is assumed to exercise significant influence, but not control, if that investor has an ownership
stake between 20% and 50% in an associate. Other indicators of significant influence include:
y Representation on the board of directors

y Participation in the policy-making process
y Material transactions between the investor and the investee
y Interchange of managerial personnel
y Technological dependency
If any of these indicators are present, the investor may exert significant influence over the associate, even if
the investor’s ownership stake is less than 20%.
Equity Method of Accounting: Basic Principles

Under both IFRS and US GAAP, investments in associates are accounted for using the equity method.
The investment is initially recognized on the investor’s balance sheet at cost (within a single line item) as
a noncurrent asset. The proportionate share of investee earnings increases the carrying amount of the
investment, while the proportionate share of losses and dividends decreases that value. The proportionate
share of investee earnings is reported within a single line item on the income statement. In contrast,
dividend payments have no impact on the amount reported on the income statement.
If the value of the investment falls to zero (eg, due to losses), use of the equity method to account for the
investment is discontinued. Use of the equity method may be resumed only if the investee subsequently
reports profits and the investor’s share of profits exceeds losses not reported by the investor since
abandoning the equity method.
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Learning Module 1
Example 1 Equity method
Alpha purchased a 20% interest in Beta for $500,000 on Jan 1 20X6. The following table lists income
reported and dividends paid by Beta for 20X6 and 20X7. Alpha uses the equity method to account for its
investment in Beta.
Income ($) Dividends ($)
20X6 350,000 100,000

20X7 500,000 150,000
Total 850,000 250,000
Determine the amount that appears on Alpha’s balance sheet for 20X7, related to its investment in Beta.
Determine the amount of investment income from Beta recognized on Alpha’s income statements for
20X6 and 20X7.
Solutions
1. The value of the investment in Beta that appears on Alpha’s 20X7 balance sheet is calculated as
the initial cost, plus Alpha’s proportionate share in Beta’s net income (for 20X6 and 20X7), minus its
proportionate share in dividends declared by Beta (for 20X6 and 20X7).
Initial cost $500,000

Add: Share of Beta’s 20X6 income (20% of 350,000) 70,000
Less: Share of dividends declared by Beta (20% of 100,000) (20,000)
Value of investment in Beta (end of 20X6) 550,000
Add: Share of Beta’s 20X7 income (20% of 500,000) 100,000
Less: Share of dividends declared by Beta (20% of 150,000) (30,000)
Value of investment in Beta (end of 20X7) $620,000
This value can be calculated as initial cost plus Alpha’s proportionate share of Beta’s cumulative
undistributed earnings since the date of the investment.
Value of investment in Beta (end of 20X7) = 500,000 + [20% × (850,000 − 250,00)] = $620,000
2. The amount recognized as investment income from Beta on Alpha’s income statement simply equals
Alpha’s proportionate share in Beta’s earnings.
Equity income for 20X6: 20% of 350,000 = $70,000

Equity income for 20X7: 20% of 500,000 = $100,000
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Amortization of Excess Purchase Price, Fair Value Option,

and Impairment
Amortization of Excess Purchase Price

If the amount paid by an investor to purchase shares in the investee is greater than the book value of those
shares (ie, the value of the investor’s proportionate share in the investee’s net identifiable tangible and
intangible assets):
y The investor first allocates the excess amount to its proportionate share in specific assets whose fair
value exceeds book value.
○ Amounts allocated to inventory are expensed.
○ Amounts allocated to depreciable or amortizable assets are capitalized and subsequently expensed
(depreciated or amortized) over an appropriate period of time.
○ Amounts allocated to land and other assets or liabilities that are not amortized continue to be
reported at fair value as of the date of investment.
y The investor then allocates remaining excess value to goodwill, which is not amortized but reviewed
periodically for impairment. The investor continues to recognize goodwill as part of the carrying amount
of the investment.
The excess of fair value over book value is not reflected in the investee’s balance sheet, nor are the
necessary periodic charges made on the investee’s income statement. The impact of these charges on the
carrying amount of the investment is recorded directly on the investor’s balance sheet and in the share of
investee profits recognized on the investor’s income statement. See Example 2.
Example 2 Equity method investments with goodwill
On Jan 1 20X7, Prime Manufacturers acquired a 25% equity interest in Alton Corp. for $700,000.
Information regarding Alton’s assets and liabilities on the date of acquisition is:
Book value ($) Fair value ($)
Current assets 220,000 220,000

PPE 1,300,000 1,500,000
Land 900,000 1,050,000
Total assets 2,420,000 2,770,000
Liabilities 750,000 750,000
Net assets 1,670,000 2,020,000
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Learning Module 1
Items of PPE are depreciated on a straight-line basis to zero over a term of 10 years.
Prime uses the equity method to account for its investment in Alton. Alton reports net income of
$250,000 for 20X7 and pays dividends of $100,000. Calculate the following:
1. Goodwill included in the purchase price

2. The amount of equity income to be reported on Prime’s income statement for 20X7
3. The value of the investment in Alton recognized by Prime on its balance sheet for 20X7
Solution
1. Purchase price $700,000

Proportionate share in book value of Alton’s net assets (417,500)
( = 25% × 1,670,000)
Excess purchase price 282,500
Less: Portion attributable to plant and equipment [ = 25% × (1,500,000 −
(50,000)
1,300,000)]
Less: Portion attributable to land [ = 25% × (1,050,000 − 900,000)] (37,500)
Goodwill (residual) $195,000
2. Proportionate share in Alton’s 20X7 earnings ( = 25% × $250,000) $62,500

Less: Amortization of excess purchase price
attributable to plant and equipment ( = 50,000 ⁄ 10) 5,000
Equity income $57,500
3. Purchase price $700,000

Add: Proportionate share in net income ( = 25% × 250,000) 62,500
Less: Dividends received ( = 25% × 100,000) (25,000)
Less: Amortization of excess purchase price
attributable to plant and equipment ( = 50,000 ⁄ 10) (5,000)
Investment balance at Dec 31 20X7 $732,500
Land is not a depreciable asset, so it will continue to be reported based on its fair value
as of the date of investment. Further, goodwill is included in the carrying amount of the
investment, not recognized separately. The investment balance/carrying amount ($732,500)
incorporates the purchase price ($700,000), which includes goodwill of $195,000.
Fair Value Option

Both US GAAP and IFRS (with certain restrictions) now offer investors the option to account for their equity
method investments using fair values. Under both standards, the decision to apply the fair value method
must be made at the time of initial recognition and is irrevocable. When the fair value method is applied:
y Unrealized gains/losses arising from changes in fair value as well as interest and dividends received
are included in the investor’s income.
y The investment account on the investor’s balance sheet does not reflect the investor’s proportionate
share in the investee’s earnings, dividends, or other distributions.
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y The excess of cost over the fair value of the investee’s identifiable net assets is not amortized.
y Goodwill is not created.
Impairment
Under both IFRS and US GAAP, equity method investments should be reviewed periodically for impairment.
Since goodwill is included in the carrying amount of the investment (ie, not separately recognized) under the
equity method, it is not tested for impairment separately.
Under IFRS, an impairment loss is recognized if there is objective evidence of a loss event and the
recoverable amount of the investment is less than the carrying amount. An investment’s recoverable
amount is the higher of its value in use (ie, PV of expected cash flows) and net selling price.
Under US GAAP, an impairment loss is recognized if the fair value of the investment is less than the
carrying amount and the decline is deemed to be permanent. Impairment results in a decrease in net
income and reduces the investment’s carrying amount on the balance sheet. Reversal of an impairment
loss is not allowed under IFRS (except for non-goodwill impairment losses) or US GAAP.
Note: When investments are accounted for using the equity method, there is a test for the total fair value of
impairment. For business combinations, there is a test for disaggregated goodwill impairment; this will be
discussed later.
Transactions with Associates and Disclosure
Profits from transactions between the investor and investee must be deferred until they are confirmed
through use or sale to a third party. This is due to the significant influence the investing company has over
the terms of transactions with associates.
Sales from investee to investor are upstream sales. The profits on such sales are recognized on the
investee’s income statement, so a proportionate share of these profits is also included in the investor’s
income statement. Sales from investor to investee are known as downstream sales, with associated profits
recognized on the investor’s income statement.
The investor’s proportionate share of unconfirmed profits from the sales, whether upstream or
downstream, must be eliminated from the investor’s equity income. The investor may recognize these
profits once they are confirmed.
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Learning Module 1
Example 3 Equity method for transactions with associates
Referring to Example 2, equity income on Prime’s (the investor’s) income statement for 20X7 is $57,500,
and the value of the investment in Alton on Prime’s balance sheet for 20X7 is $732,500. Suppose that
the following transactions also took place:
1. $12,000 of profit from an upstream sale from Alton to Prime during 20X7 was still in Prime’s
inventory at the end of 20X7 as the goods had not yet been sold to an outside investor.
2. During 20X9, Prime made downstream sales of $100,000 worth of goods to Alton for $160,000, and
Alton sold goods worth $140,000 to outside parties, while the remaining $20,000 worth of goods
was sold in 20X8.
Calculate the amount of equity income reported on Prime’s income statement for 20X7 and the value
of the investment in Alton on Prime’s 20X7 balance sheet after incorporating the effects of the above
transactions.
Solution
1. Upstream sale
Unrealized profit = $12,000

Prime’s proportionate share of the unrealized profit = 25% × 12,000 = $3,000
2. Downstream sale
Prime’s profit on sale to Alton = 160,000 − 100,000 = $60,000

Alton sells 87.5% (= 140,000 / 160,000 × 100) of goods purchased from Prime during 20X9, while
12.5% remains unsold.
Therefore, total unrealized profit = 12.5% × 60,000 = $7,500
Prime’s proportionate share of unrealized profit = 25% × 7,500 = $1,875. Therefore:
Revised equity income for 20X9 = 57,500 − 3,000 − 1,875 = $52,625
Revised carrying value of investment for 20X9 = 732,500 − 3,000 − 1,875 = $727,625
In 20X8, when unconfirmed sales for 20X7 (worth $20,000) are confirmed, related profits that were not
realized during 20X7 (worth $1,875) are realized. These profits contribute to equity income for 20X8.
Disclosure
In practice, associates’ results may be included in the investor’s reporting with a time lag. Since associate-
issued dividends are already reported as earnings, they are not reported on the investor’s income
statement, which would double-count them. On the consolidated balance sheet, the book value of the
investor’s holdings is increased by its proportionate share of associate income and decreased by its
proportionate share of associate dividends.
Issues for Analysts

Analysts should evaluate the appropriateness of the use of the equity method for accounting for investment
in an associate. For example, in a situation where an investing company owns a 30% equity interest in an
associate but does not exert significant influence over the investee, the investor may prefer using the equity
method so that it can report associated income on its financial statements.
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On the other hand, if an investing company owns a 19% equity interest in an associate but exerts significant
influence over the investee, the investor may prefer not to use the equity method in order to avoid
recognition of its proportionate share of investee losses on its financial statements.
The investment is presented on the investor’s balance sheet as a single line item. This affects the leverage
ratios reported by the investor as the investor’s proportionate share of the investee’s assets and liabilities is
not reported separately on its financial statements.
Since the investor’s proportionate share in associate earnings is reported on its income statement, but its
proportionate share in associate revenues is not, the net profit margin may be overstated.
The equity method assumes that the investor’s proportionate share of each dollar earned by the associate
is available to the investor, even if earnings are not distributed as dividends. Analysts should therefore
consider any restrictions on dividend payments.
Acquisition Method
A business combination refers to the combination of two or more entities into a larger economic entity. IFRS
do not differentiate between business combinations based on the structure of the surviving entity, but US
GAAP do, categorizing business combinations as shown in Exhibit 3.
Exhibit 3 Classification of business combinations: US GAAP
Acquisition
y Parent and subsidiary continue to operate as separate entities

y Parent can acquire < 100%
y Parent can own < 50% and still have control
y A = B = (A + B)
Consolidation
y Parent must acquire 100% of subsidiary

y Neither parent nor subsidiary exist as entities after transaction
y A+B=C
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Learning Module 1
Merger
y Parent must acquire 100% of subsidiary

y Only parent exists after transaction
y A+B=A
In the past, business combinations could be accounted for using either the purchase method or the
uniting-of-interests (or pooling-of-interests) method. Those methods have been replaced, however, by
the development of the acquisition method, which minimizes differences between IFRS and US GAAP in
accounting for such combinations.
Acquisition Method
Under the acquisition method, all assets, liabilities, revenues, and expenses of the acquiree are combined
with those of the parent. The acquired entity’s identifiable tangible and intangible assets and liabilities are all
measured at fair value.
Recognition and Measurement of Identifiable Assets and Liabilities

The acquirer must recognize any identifiable tangible or intangible assets and liabilities, even if the acquiree
had not recognized them on its financial statements. For example, identifiable intangible assets such as
brand names and patents that the acquiree had developed internally would be recognized by the acquirer.
Recognition and Measurement of Contingent Liabilities

The acquirer must recognize any contingent liability assumed in the acquisition if (1) it is a present
obligation that arises from past events, and (2) it can be measured reliably. However, costs that the acquirer
expects but is not obliged to incur are not recognized as liabilities. Instead, they are expensed in future
periods as they are incurred.
Recognition and Measurement of Indemnification Assets

The acquirer must recognize an indemnification asset if the acquiree contractually indemnifies the acquirer
for the outcome of a contingency, an uncertainty related to a specific asset or liability of the acquiree, or
against losses above a specified amount on a liability arising from a particular contingency.
Recognition and Measurement of Financial Assets and Liabilities

Upon acquisition, assets and liabilities are reclassified based on contractual terms, economic conditions,
and the acquirer’s accounting policies.
Recognition and Measurement of Goodwill

IFRS allow for the recognition of partial or full goodwill, whereas US GAAP allow only full goodwill. Both
are intangible assets that represent the difference between the acquisition price and the value of net
assets. Partial goodwill considers only the acquirer’s proportional share of the fair value of net assets; full
goodwill accounts for the fair value of all net assets. Goodwill is not amortized, but it is tested annually
for impairment.
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Recognition and Measurement When Acquisition Price Is Less Than Fair Value
If the purchase price is less than the fair value of the subsidiary’s (ie, acquiree’s) net assets, it is referred
to as a bargain acquisition. Both IFRS and US GAAP require the difference between the fair value of the
acquired net assets and the purchase price to be recognized immediately as a gain in profit or loss.
Example 4 Acquisition method
Pyramid Inc. acquired a 100% equity interest in Sam Corp. by issuing 1 million shares of common stock.
The par value of each share was $1, while the market price of each share at the time of the transaction
was $10. The following information (in $ thousands) relates to the two companies just before the
transaction.
Pyramid Inc. Sam Corp.
Book value Book value Fair value
Cash and receivables 12,500 450 450

Inventory 11,000 1,500 3,500
Net PPE 25,500 2,800 4,000
Total assets 49,000 4,750 7,950
Current payables 7,500 800 800
Long-term (LT) debt 15,000 2,500 2,000
Total liabilities 22,500 3,300 2,800
Net assets 26,500 1,450 5,150
Capital stock ($1 par) 5,500 300
Additional paid-in capital 7,000 400
Retained earnings 14,000 750
Total shareholders’ equity 26,500 1,450
Based on the acquisition method, calculate the amounts presented on the post-combination balance
sheet. Assume that Sam has no identifiable intangible assets.
Solution
Under both IFRS and US GAAP, the purchase price equals the fair value (FV) of shares issued by
Pyramid to finance the acquisition. Since the purchase price ($10 million) exceeds the book value (BV)
of Sam’s net assets ($1.45 million), the excess is allocated to identifiable assets and liabilities to reflect
their fair values, and the remainder is recognized as goodwill.
Excess purchase price = Cost of acquisition − BV of net assets acquired
($10 × 1,000,000) − $1,450,000 = $ 8,550,000
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Learning Module 1
Excess purchase price $8,550,000

Allocated to identifiable net assets:
Inventory (difference between BV and FV of Sam’s inventory) 2,000,000
PPE (difference between BV and FV of Sam’s net PPE) 1,200,000
Long-term debt (difference between BV and FV of LT debt) 500,000
Allocated to goodwill (remaining amount of excess purchase price) 4,850,000
Total 8,550,000
For the consolidated balance sheet, assets and liabilities are combined using the book values of
Pyramid’s assets and liabilities and the fair value of Sam’s assets and liabilities. Further, only Pyramid’s
retained earnings are carried to the combined equity.
Consolidated Balance Sheet ($ thousands)
Cash and receivables (= 12,500 + 450) 12,950

Inventory (= 11,000 + 3,500) 14,500
PPE (= 25,500 + 4,000) 29,500
Goodwill 4,850
Total assets 61,800
Current payables (= 7,500 + 800) 8,300
Long-term debt (= 15,000 + 2,000) 17,000
Total liabilities 25,300
Capital stock ($1 par) (= 5,500 + 1,000) 6,500
Additional paid-in capital (= 7,000 + 9,000) 16,000
Retained earnings 14,000
Total equity 36,500
Total liabilities and shareholders’ equity 61,800
Calculations
Capital stock = Parent’s capital stock + Par value of shares issued
= $5,500,000 + $1,000,000 = $6,500,000
Additional paid-in capital = Parent’s additional paid-in capital + (Market value of shares issued − Par
value of shares issued)
= $7,000,000 + [(1,000,000 × 10) − (1,000,000 × 1)] = $16,000,000
Also, note that in post-acquisition periods, amortization and depreciation will be based on the historical
cost of Pyramid’s assets and the fair value (as of the acquisition date) of Sam’s assets. So, under the
acquisition method, as Sam’s inventory is sold, COGS would be $2,000,000 higher, and depreciation
on PPE would be $1,200,000 higher over the life of assets. This is in contrast to the pooling-of-interests
method, in which the companies’ book values are combined.
Important: At the date of acquisition, only the acquirer’s retained earnings are carried over to the combined
entity. The acquiree’s earnings and retained earnings are included on the consolidated income statement
only in post-acquisition periods.
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The Consolidation Process
Consolidated financial statements report the combined financial results of a parent and its subsidiaries,
although they may be separate legal entities. All assets, liabilities, revenues, and expenses of both the
parent and its subsidiaries are reported; transactions between the parent and subsidiaries are excluded to
avoid double-counting them.
Business Combinations with Less Than 100% Acquisition

In an acquisition, the acquirer may not purchase 100% of the target’s equity to gain control. In that case, the
acquirer and the target remain separate legal entities, known as the parent and the subsidiary. The parent
and the subsidiary prepare their own financial statements, but the parent also prepares consolidated
financial statements for each reporting period.
Noncontrolling (Minority) Interests: Balance Sheet

If a parent controls a subsidiary but owns less than a 100% equity interest in the company, it must also
create a noncontrolling interest account on the consolidated balance sheet and income statement in
order to reflect the proportionate share in the subsidiary’s net assets and net income held by minority
shareholders (ie, shareholders other than the parent). Their share in the net assets of the subsidiary
is included in the noncontrolling interests account on the consolidated balance sheet (presented in the
equity section).
IFRS and US GAAP differ regarding the balance sheet measurement of noncontrolling interests. US GAAP
requires the parent to measure noncontrolling interest at fair value (ie, full goodwill method). IFRS permits
the parent to report the noncontrolling interest either at fair value or as the proportionate share of the fair
value of the subsidiary’s identifiable net assets (ie, partial goodwill method).
Noncontrolling (Minority) Interests: Income Statement

The noncontrolling interests account income statement (deducted from consolidated net income) reflects
minority shareholders’ proportionate share in the net income of the subsidiary.
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Learning Module 1
Example 5 Goodwill and noncontrolling interests
On Jan 1 20X0, Pluto Inc. acquired a 90% equity interest in Jupiter Inc. in exchange for €450,000 worth
of Pluto stock. The fair market value of Jupiter on the date of acquisition was €500,000. The following
information is available about the two companies immediately prior to the transaction.
Pluto Jupiter
Book value (€) Book value (€) Fair value (€)
Cash and receivables 50,000 20,000 20,000

Inventory 130,000 95,000 95,000
Net PPE 250,000 110,000 160,000
Total assets 430,000 225,000 275,000

Payables 60,000 25,000 25,000
Long-term debt 100,000 60,000 60,000
Total liabilities 160,000 85,000 85,000
Net assets 270,000 140,000 190,000
Capital stock 90,000 50,000
Retained earnings 180,000 90,000
Total shareholders’ equity 270,000 140,000
y Calculate the value of goodwill and noncontrolling interest at the acquisition date under the full
goodwill method.
y Calculate the value of goodwill and noncontrolling interest at the acquisition date under the partial
goodwill method.
y Compare the post-combination balance sheets under the full goodwill and partial goodwill methods.
Solutions
Full Goodwill Method
Goodwill equals the excess of the total fair value of the subsidiary over the fair value of its identifiable net
assets.
y Subsidiary’s fair value = €500,000
y Fair value of subsidiary’s identifiable net assets = €190,000
y Goodwill = $500,000 − €190,000 = €310,000
The noncontrolling interest is measured based on its proportionate share of the subsidiary’s fair value.
Noncontrolling interest (NCI) = Percentage of NCI × Subsidiary’s fair value = 10% × 500,000 = €50,000
Vol 2-18
Partial Goodwill Method
Goodwill equals the excess of the purchase price over the fair value of the parent’s proportionate share
in the subsidiary’s identifiable net assets.
y Acquisition price = €450,000

y Fair value of proportionate share of acquired net assets = 90% × €190,000 = €171,000
y Goodwill = 450,000 − €171,000 = €279,000
The noncontrolling interest is measured based on its proportionate share of the fair value of the
subsidiary’s identifiable net assets.
NCI = Percentage of NCI × Fair value of subsidiary’s identifiable net assets = 10% × €190,000 = €19,000
Post-combination balance sheets
Consolidated Balance Sheet
Full goodwill (€) Partial goodwill (€)
Cash and receivables 70,000 70,000

Inventory 225,000 225,000
PPE 410,000 410,000
Goodwill 310,000 279,000
Total assets 1,015,000 984,000
Payables 85,000 85,000
Long-term debt 160,000 160,000
Total liabilities 245,000 245,000
Noncontrolling interests 50,000 19,000
Capital stock (= 90,000 + 450,000) 540,000 540,000
Retained earnings 180,000 180,000
Total equity 770,000 739,000
Total liabilities and shareholders’ equity 1,015,000 984,000
The full goodwill method results in higher total assets and equity compared with the partial goodwill
method.
As demonstrated in Example 5, net income to the parent’s shareholders will be the same regardless of
whether the full goodwill or partial goodwill method is used to value goodwill and noncontrolling interests on
the balance sheet. On the income statement, the noncontrolling interests will share the burden of additional
depreciation that arises from the €50,000 increase in PPE. Since depreciation expense is the same under
both methods, net income and retained earnings (€180,000) on the consolidated balance sheet are also the
same under both methods.
Although net income is the same, return on assets and return on equity will be less if the full goodwill
method is used since it results in more assets and more equity than the partial goodwill method. In addition,
over time, the value of the subsidiary will change due to changes in equity or net income. Therefore, the
value of noncontrolling interest on the consolidated balance sheet will also change.
Vol 2-19
Learning Module 1
Goodwill Impairment
Since goodwill is an intangible asset with an indefinite life, it is not amortized. However, goodwill must be
tested for impairment at least annually—or more often, if events and circumstances indicate that it may be
impaired. Once an impairment charge has been made against goodwill, it cannot be reversed.
Exhibit 4 shows the differences between IFRS and US GAAP in accounting for goodwill impairment. Note
the following definitions:
y Cash-generating unit: The smallest group of assets that can operate independently and generate cash
y Reporting unit: Smaller unit within an operating segment
y Recoverable amount: The greater of the net selling price and value in use (ie, PV of
expected cash flows)
y Implied fair value: Fair value of reporting unit − Fair value of reporting unit’s assets and liabilities
Exhibit 4 Goodwill impairment under IFRS and US GAAP
IFRS US GAAP
At acquisition,
Cash-generating units Reporting units
goodwill allocated to:
Impairment test Recoverable amount < Carrying amount Fair value < Carrying value
Impairment loss Carrying value − Recoverable amount Carrying value − Implied fair value
Impairment loss
Cash-generating unit’s goodwill Reporting unit’s goodwill
applied first to:
After reporting unit’s Remaining amount of loss is allocated No adjustments are made to the
goodwill has been to all other assets in the unit on a pro carrying amounts of unit’s other
reduced to zero: rata basis. assets or liabilities
Under both IFRS and US GAAP, the impairment loss is recognized as a separate line item on the
consolidated income statement.
Example 6 Impairment of goodwill under IFRS
An analyst obtains the following information regarding a cash-generating unit of Mercury Inc.:
y Carrying value of unit (including recognized goodwill of $600,000) = $2,600,000
y Recoverable amount of unit = $2,200,000
y Fair value of unit’s identifiable net assets = $1,900,000
Calculate the impairment loss recognized under IFRS.
Vol 2-20
Solution
Impairment loss = Carrying value of unit − Recoverable amount of unit
Impairment loss = $2,600,000 − $2,200,000 = $400,000
Note: If the recoverable amount of the cash-generating unit had been $1,900,000 instead of $2,200,000,
the impairment loss would have been $700,000. This would be absorbed first by goodwill allocated to
the unit ($600,000); the remaining amount of the impairment ($700,000 − $600,000 = $100,000) would
then be allocated on a pro rata basis to other assets within the unit.
Example 7 Impairment of goodwill under US GAAP
An analyst obtains the following information regarding a reporting unit of Mercury Inc.:
y Carrying value of unit (including recognized goodwill of $600,000) = $2,500,000

y Fair value of unit = $2,100,000
y Fair value of unit’s identifiable net assets = $1,900,000
Calculate the impairment loss recognized under US GAAP.
Solution
Step 1: Determine whether goodwill is impaired.
Since the carrying value ($2.5 million) of the reporting unit exceeds its fair value ($ 2.1 million),
impairment exists.
Step 2: Measure the impairment loss.
Implied goodwill = Fair value of unit − Fair value of identifiable net assets of the unit
Implied goodwill = $2,100,000 − 1,900,000 = $200,000
Impairment loss = Recognized goodwill − Implied goodwill
Impairment loss = $600,000 − 200,000 = $400,000
If the fair value of the unit had been $1,200,000 instead of $2,100,000, the implied goodwill would equal
−$700,000. In that case, the maximum impairment loss recognized would be capped at the carrying
value of goodwill ($600,000).
Vol 2-21
Learning Module 1
Special Purpose and Variable Interest Entities
Special purpose entities (SPEs) are established to meet specific objectives of the sponsoring company.
They are structured in a manner that allows the sponsoring company to retain financial control over the
SPE’s assets and/or operating activities, while third parties hold the majority of the voting interest in the
SPE. Typically, third parties fund their investments in SPEs with debt that is directly or indirectly guaranteed
by the sponsoring company.
In the past, such arrangements enabled sponsoring companies to avoid consolidation of SPEs on their
financial statements due to a lack of "control" (ie, ownership of a majority voting interest) of the SPE. As a
result, sponsoring companies were able to:
y avoid disclosures of guarantees they had made regarding the SPE’s debt.
y transfer assets and liabilities from their own balance sheets to the SPE and record revenues and gains
related to these transactions.
y avoid recognition of the SPE’s assets and liabilities on their financial statements.
Consequently, a sponsoring company’s reported financial performance—as presented in unconsolidated

financial statements—would be economically misleading since it indicated improved asset turnover,
higher profitability, and lower levels of operating and financial leverage. (Enron is an excellent example
of a company that used off-balance-sheet financing to improve its reported financial performance. The
company’s subsequent collapse was, in part, related to the guarantees it provided on the debt of SPEs it
had created.)
IFRS and US GAAP now require sponsoring companies to prepare consolidated financial statements that
account for arrangements in which parties other than the holders of majority voting rights exercise financial
control over the sponsored entity. Further, standards relating to the measurement, reporting, and disclosure
of guarantees have been revised.
For example, under US GAAP, a variable interest entity (VIE) must be consolidated as the subsidiary
of its primary beneficiary, regardless of how much equity investment that beneficiary has in the VIE.
VIEs are defined by US GAAP as any entity controlled by a party that does not hold a majority voting
interest. In a VIE:
y The primary beneficiary (often the sponsor) is defined as the entity that is expected to absorb the
majority of the VIE’s expected losses, receive the majority of the VIE’s residual returns, or both.
y If one entity is expected to absorb a majority of the VIE’s losses while another entity would receive a
majority of its expected profits, the entity absorbing a majority of the losses must consolidate the VIE.
y If there are noncontrolling interests in the VIE, these would also be shown in the consolidated balance
sheet and consolidated income statement of the primary beneficiary.
Vol 2-22
Securitization of Assets
SPEs are often set up to securitize receivables held by the sponsor. The SPE issues debt to finance the
purchase of the receivables from the sponsor, and interest and principal payments to debt holders are made
from the cash flow generated from the pool of receivables.
The sponsor’s motivation for selling its accounts receivable to the SPE is to accelerate cash inflows.
However, an important aspect of the arrangement is that the SPE’s debt holders need to have recourse
against the sponsor if sufficient cash is not generated from the pool of receivables. Therefore, the
transaction is basically treated like a loan taken out by the sponsor and collateralized with the receivables. If
the receivables are not entirely realized, the loss is borne by the sponsor.
When the receivables are first sold by the sponsor, accounts receivable decrease, and the cash received
contributes to CFO. However, if the risk of nonrealization is still borne by the sponsor (eg, through a debt
guarantee), an analyst must adjust accounts receivable and current liabilities upward. Further, the cash
inflow previously classified as CFO must be reclassified as cash flow from financing activities (CFF) to
reflect the fact that the transaction is, in effect, merely a collateralized borrowing. See Example 8.
Exhibit 5 Adjusted values when reclassifying sale of receivables
CFO Lower
CFF Higher
Total cash flow Same
Current assets Higher
Current liabilities Higher
Current ratio (assuming it was greater than 1) Lower
Example 8 Securitization of receivables
Violet Inc. wants to raise $75 million in capital by borrowing against its financial receivables. The
company’s finance director presents the following two options to senior management:
Option 1: Borrow directly against accounts receivable.
Option 2: Create a SPE with an initial investment of $10 million, have the SPE borrow $75 million, and
then use those funds to purchase $85 million of Violet’s receivables.
Vol 2-23
Learning Module 1
The following balance sheet information is available:
Cash 40,000,000
Accounts receivable 85,000,000
Other assets 35,000,000
Total assets 160,000,000
Current liabilities 30,000,000

Noncurrent liabilities 35,000,000
Total liabilities 65,000,000
Shareholders’ equity 95,000,000

Total liabilities and shareholders’ equity 160,000,000
Selected financial ratios
Current ratio = 4.17
Long-term debt-to-equity ratio = 0.37
Equity to total assets = 0.59
Prepare Violet’s balance sheet as it would appear after it raises the required amount under either
alternative.
Solution
Option 1: Borrow directly against the receivables
Violet’s cash and noncurrent liabilities will increase by $75 million.
Cash 115,000,000


Vol 2-24
Equity-to-total assets ratio = 0.40
Relative to its original balance sheet, if Violet borrows directly against the receivables:
y It reports higher total assets and higher total liabilities. Therefore, the equity-to-total assets ratio is
lower (worse).
y Profitability ratios (eg, return on assets, return on total capital) are lower (worse).
y The long-term debt-to-equity ratio is higher (worse).
y The current ratio is higher (better).
Option 2: Establish a SPE
Violet’s accounts receivable will decrease by $85 million, and cash will increase by $75 million
(calculated as proceeds from the sale of receivables, $85 million, minus the amount invested in the SPE,
$10 million). The investment in the SPE is listed under assets on the balance sheet.
Cash 115,000,000
Accounts receivable 0
Investment in SPE 10,000,000


Relative to its original balance sheet, if Violet establishes a SPE to raise funds and does not
consolidate the SPE’s financial statements with its own:
y Total assets and liabilities remain unchanged. Therefore, the company’s long-term debt-to-equity
ratio and its equity-to-total assets ratio are unaffected.
y The increase in cash ($75 million) is lower than the decrease in accounts receivable ($85 million),
which reduces current assets. Therefore, the current ratio is lower (worse).
Vol 2-25
Learning Module 1
If Violet consolidates the financial statements of the SPE, its balance sheet will look like this:
Cash 115,000,000

Noncurrent liabilities ( = 35 million + 75 million) 110,000,000

If Violet were required by accounting standards to consolidate the SPE’s financial statements with its
own, its financial ratios would be the same as those calculated under Option 1.
The table below summarizes financial statement ratios based on reported financials under the different
options:
With SPE
Selected ratios Original Direct borrowing Unconsolidated Consolidated
Current ratio 4.17 6.67 3.83 6.67

Long-term debt to equity 0.37 1.16 0.37 1.16
Equity to total assets 0.59 0.40 0.59 0.40
Note: If Violet were able to raise funds by establishing a SPE without a requirement to present
consolidated financial statements, it would report a lower (better) debt-to-equity ratio (0.37) and higher
(better) equity-to-total assets ratio (0.59), compared with direct borrowing (1.16 and 0.40, respectively).
However, if accounting standards were to require consolidation of SPEs, Violet’s presented financial
position would be the same regardless of whether it raised the funds through a SPE or by borrowing
directly (D/E = 1.16; E/A = 0.40)
Vol 2-26
Additional Issues in Business Combinations That Impair

Comparability
Contingent Assets and Liabilities

IFRS and US GAAP differ regarding the treatment of contingent assets and liabilities.
Under IFRS, contingent assets are not recognized. Contingent liabilities are recognized separately during
the cost allocation process, given that their fair values can be reliably measured.
Under US GAAP, contractual contingent assets and liabilities are recognized at their fair values at the time
of acquisition. Noncontractual contingent assets and liabilities may also be recognized if it is probable (ie,
more likely than not) that they meet the definition of an asset or liability at the acquisition date.
Contingent Consideration
Contingent consideration is created when a parent agrees to pay additional amounts to the subsidiary’s
shareholders if the combined entity achieves certain performance targets. Under both IFRS and US GAAP,
contingent consideration should be measured initially at fair value and classified as a financial liability or
equity. Subsequent changes in the fair value of such liabilities (and assets, in the case of US GAAP) are
recognized in the consolidated income statement. Contingent consideration classified as equity is not
remeasured under IFRS or US GAAP. Any settlements are accounted for within equity.
In-process R&D
Under both IFRS and US GAAP, in-process research and development (R&D) acquired in a business
combination is recognized as a separate intangible asset at fair value. In subsequent periods, in-process
R&D is amortized.
Restructuring Costs
Under both IFRS and US GAAP, restructuring costs associated with a business combination are expensed
in the period in which they are incurred. These costs are not included in the acquisition price.
Vol 2-27
Learning Module 1
Vol 2-28
Learning Module 2
Employee Compensation:
Post-Employment and Share-Based
LOS: Contrast types of employee compensation.
LOS: Explain how share-based compensation affects the financial statements.
LOS: Explain how to forecast share-based compensation expense and shares outstanding in a
financial statement model and their use in valuation.
LOS: Explain how post-employment benefits affect the financial statements.
LOS: Explain financial modeling and valuation considerations for post-employment benefits.
Types of Employee Compensation
LOS: Contrast types of employee compensation.
Companies can offer several types of benefits to their employees (eg, pension plans, health care plans,
medical insurance). The main differences between forms of compensation relate to when the benefits are
paid and how they are paid. Exhibit 1 provides examples of compensation types:
Exhibit 1 Forms of compensation
Type of compensation Examples
Salaries, bonuses, retirement

Short-term
contributions, health insurance
Long-term paid leave,

Long-term
long-term disability
Termination Severance pay, career counseling
Share-based Restricted stock, stock options
Post-employment Pensions, life & health insurance
Vol 2-29
Learning Module 2
If a company reports under IFRS, all the compensation forms listed in Exhibit 1 are expensed at fair
value when the compensation vests in the employee. Vesting is defined as the employee’s having an
unconditional right to receive the compensation, even if actual receipt will not occur until some time
in the future.
For cash (ie, short-term) compensation, the:
y income statement shows an expense for the amount of compensation.

y balance sheet shows a liability for deferred compensation (until cash payment).
y statement of cash flows shows an entry for cash from operations (CFO) for the period when the
compensation is paid.
Share-Based Compensation
As indicated in Exhibit 1, employees may have a portion of their compensation paid in shares of the
company’s common stock. Such compensation is typically offered to align the employees’ interests with
those of highly compensated management and non-employee shareholders or to improve employee
retention. It may prove ineffective or even backfire if the recipients have limited opportunities to affect share
price or cannot do so without modifying their risks. However, an advantage of share-based compensation
is that no immediate cash outlay is required; compensation is provided as shares of stock or options/
warrants on shares.
Exhibit 2 Advantages and disadvantages of share-based compensation
Advantages Disadvantages
y Employee motivation with the y Limited influence over firm value or stock price
possibility of higher earnings may weaken motivation
y Stock ownership may increase risk aversion,

y Incentive to align interests of leading to less profitable projects
shareholders and employees y Asymmetrical payout of options may increase
risk appetite, leading to riskier projects
y Potentially no cash y Equity-settled compensation can cause

disbursements required dilution of shares
Financial Reporting for Share-Based Compensation
Under IFRS, compensation paid in shares is provided over a timeline of events: shares are granted,
followed by a period of vesting that ends on a settlement date. The fair value of the shares at the time of the
grant is apportioned over the vesting period, impacting both the income statement and balance sheet each
year of that period. This is the case even if the employee is not vested in any of the shares until the vesting
period has been completed.
Vol 2-30
Employee Compensation: Post-Employment and Share-Based
y The income statement will report compensation expense annually during the vesting period. The
amount reported each year is the prorated amount of the shares’ initial fair value.
y On the balance sheet, the amount of compensation expense is reported in a share-based
compensation reserve account under equity. At the end of the vesting period, the entire fair value is
transferred from the reserve account into the common stock/paid-in capital account.
The fair value of the shares is measured only on the date of grant. It is not adjusted regardless of changes
to the share price during the vesting period. However, future grants will have a fair value based on the share
price at the time of those grants.
For share-based compensation, vesting can be based on:
y Service: The employee must remain employed for a given period. If the employee leaves before the
end of the period, the grant is void and the employee is not entitled to any of the grant. A lapsed grant
may require a company to adjust its statements retroactively.
y Performance: This is usually an additional condition to service. It requires that the company satisfy a
metric such as EPS or net income.
y Market conditions: The share price must be at or above a specified value. This is often another type
of performance condition.
Four different types of instruments can be used for share-based compensation. Exhibit 3
provides a summary:
Exhibit 3 Share-based compensation instruments
Instrument Features
y Shares, or restricted share units

(RSUs) that are exchanged for shares
upon settlement
Restricted stock ○ Restricted shares have voting rights
and receive dividends
○ RSUs have no voting rights and do
not receive dividends
y Call options on company shares

Options ○ Not tradeable
○ Strike price = Share price at issuance
y Cash or stock awarded based on share

Stock: appreciation-based
performance
y Employees purchase newly issued

Stock: purchase-based
shares at a discount
Vol 2-31
Learning Module 2
Restricted Stock
Restricted stock refers to grants made to employees of the company’s common stock that vest at some
future date. The conditions for vesting could be the employee’s years of service, the company’s attainment
of certain goals (eg, EPS, sales), or both. Restricted stock units (RSUs) are similar to restricted stock, but
instead of actual shares, they are instruments that can be exchanged for common stock upon settlement.
The fair value for both restricted stock and RSUs is the share price on the date of the grant. The company’s
share-based compensation expense for the period is the product of:
y the number of shares of restricted stock,

y the price per share, and
y the percentage of restricted stock that vests during the period.
Stock Options
Employee stock options are call options on the company’s common stock. The options are not tradeable,
and they are usually issued with a strike price equal to the share price on the date of the award. The share-
based compensation expense attributable to options is the product of:
y the number of options issued,

y the fair value of each option, and
y the percentage of options that are exercisable in each period.
The fair value of stock options is not easy to estimate. Stock option value has two elements: intrinsic value
and time value. Time value can be a significant percentage of option value when there is a long time until
the option can be exercised. Companies have significant discretion under both IFRS and US GAAP to
determine a model for valuing employee stock options.
Example 1 Share-based compensation expense from restricted stock and options
ABC Company instituted a stock grant program on Jan 1 20X2 and will issue 100,000 RSUs each
year; 25 percent of the RSUs vest each year over four years beginning in 20X2. At the same time, ABC
granted 30,000 stock options. Each option can be exercised to purchase one share of ABC common
stock for $50. The stock options vest 50% each year, also beginning in 20X2.
Price per share:
Jan 1 20X2: $50
Jan 1 20X3: $60
The fair value of each option is assumed to be $8.
What is ABC’s total share-based compensation in 20X2 and 20X3?
Vol 2-32
Solutions
20X2:
RSU share-based compensation expense = 100,000 × 0.25 × $50 = $1,250,000
Option share-based compensation expense = 30,000 × 0.50 × $8 = $120,000
Total share-based compensation expense in 20X2 = $1,250,000 + 120,000 = $1,370,000
20X3:
RSU share-based compensation expense = 100,000 × 0.25 × $60 = $1,500,000
Option share-based compensation expense = 30,000 × 0.50 × $8 = $120,000
Total share-based compensation expense in 20X3 = $1,500,000 + 120,000 = $1,620,000
Share-Based Compensation Tax and Share Count Effects,

Note Disclosures
Share-based compensation is generally deductible, but there can be timing differences based on reporting
requirements:
y For financial reporting, share-based compensation expense is reported ratably each year over
the vesting period, and the amount of the expense is based on the fair value of the grant on the
date of grant.
y For tax reporting, the deduction is allowed only after the settlement date.
○ For stock, the value of the deduction is the share price on the settlement date.
○ For options, the value of the deduction is the options’ intrinsic value at exercise.
These requirements can result in the grantor receiving a greater tax deduction if the share price increases
between the grant date and settlement date, but a smaller tax deduction if the share price decreases in the
same period. Under IFRS, any gains or losses caused by the different deductions are applied directly to
shareholder equity on the balance sheet. Under US GAAP, the gains (losses) increase (decrease) income
tax expense on the income statement if the share price on the settlement date is greater than (less than)
the price on the grant date.
Currently, most share-based grants are in restricted stock, rather than options. Employees may prefer
restricted stock since it will have some value even if the price declines. In contrast, options will have no
value if the share price is below the strike price on the exercise date. Also, restricted stock is easier for
employees to understand and does not require any future cash outlay to obtain stock. Thus, restricted stock
may better align shareholder and employee interests.
Vol 2-33
Learning Module 2
Share-Based Compensation and Shares Outstanding

The number of common shares reported as outstanding increases during the period that grants settle; any
grants that have not settled are not included in that number. The resulting dilution of existing shares can be
offset by share repurchases.
Since shares that have not yet settled are not outstanding, they are not included in calculating basic EPS,
but they are included in calculating diluted EPS. The calculation of diluted EPS uses the treasury stock
method, which relies on several assumptions:
y All restricted shares and RSUs are immediately vested and settled. However, management has
discretion to include only all restricted shares likely to vest and settle. This generally means that they
include shares vested based on service but exclude shares vested based on performance.
y The company’s average unrecognized share-based compensation expense for the period can be
added back since that expense will not be paid, assuming settlement and exercise.
y Options are exercised if they are in the money, that is, if the average share price over the period is
greater than the exercise price.
y All proceeds from settlement and exercise are used to repurchase shares.
Therefore, the calculation of diluted EPS includes share-based awards that actually vest and settle
during the period, as well as the company’s average unrecognized share-based compensation expense
for the period.
Companies reporting under IFRS must disclose the types of share-based compensation arrangements
used, the determination of the fair value of the instruments granted during the period, and the impact of the
share-based transactions on the company’s net income (or loss) and financial position.
Share-Based Compensation and Financial Statement Modeling
LOS: Explain how to forecast share-based compensation expense and shares outstanding in a
financial statement model and their use in valuation.
Analysts often need to forecast future share-based compensation expenses. The common approach is
to forecast future share-based expense as a percentage of revenues. This affords the analyst flexibility to
utilize different forecasting techniques, such as historical average, management guidance, or reversion to a
mean figure over time.
Forecasting Shares Outstanding With Share-Based Awards

EPS can be affected by the existence of dilutive shares, which can arise through share-based
compensation. Therefore, when forecasting EPS, analysts need to estimate with some degree of accuracy
how many common shares will exist in the future. This estimate, in turn, requires estimating how many
dilutive shares will be created.
Determining the future number of dilutive shares can be difficult as disclosures do not always provide
sufficient detail. One technique is to assume that a constant percentage of share awards is dilutive based
on historical observations. Stock options also impact forecasted cash flows, along with additional shares,
while RSUs do not impact cash flows.
Vol 2-34
Valuation Considerations With Share-Based Compensation

Analysts must consider share-based compensation in a valuation since the additional shares dilute existing
shareholders’ interests. Also, companies often offset the dilutive effect of compensation by repurchasing
shares in the open market, which creates a shareholder distribution.
Discounted cash flow models must be modified to account for the dilution from outstanding but unvested
awards and from future awards. For outstanding but unvested awards, the analyst can use diluted shares
outstanding plus anti-dilutive securities for determining per-share values in the model; another approach is
to add the gross amount of potentially dilutive securities to basic shares outstanding. For estimating dilution
from future awards, the curriculum suggests deducting share-based compensation from free cash flow as
the most practical approach.
Financial Reporting for Post-Employment Benefits
LOS: Explain how post-employment benefits affect the financial statements.
Post-employment benefits are classified as defined contribution (DC) or defined benefit (DB) plans. DC
plans are much simpler to implement and maintain. In a DC plan, the employer (also known as the sponsor)
establishes the plan, selects investment options, and establishes separate accounts for each of the
employees (ie, the participants). The sponsor makes predefined contributions to each participant’s account,
while participants can also make their own contributions. However, investment decisions in a DC plan are
made only by the participant. The sponsor assumes no responsibility for investment performance and has
no liability for any investment losses suffered by the participants.
DB plans create a sponsor obligation: a benefit to be paid in retirement. The benefit may be a lump sum or
an annuity paid over some fixed or indeterminate period. The amount of the benefit is typically based on
some combination of years worked and compensation. The sponsor makes periodic payments into the plan,
and in most cases those payments are tax deductible. Since the sponsor has promised the benefit, most
regulations require the sponsor to prefund the retirement payments, which means that contributions for a
younger participant may begin decades before the participant receives benefits.
Another type of DB plan does not pay money benefits in retirement, but instead a benefit such as life and/or
health insurance. Such plans are broadly referred to as other post-employment benefit (OPEB) plans.
OPEB plans usually do not require any prefunding.
Financial Reporting for DC Plans

For DC plans, the sponsor’s contribution is recorded as an expense on the income statement. There are no
balance sheet consequences, unless the sponsor has not yet made the agreed-upon contribution for the
period; in that case, the sponsor would show a current liability for the amount of the contribution.
Financial Reporting for DB Plans

Under both IFRS and US GAAP, the DB liability (or asset) reported on the balance sheet equals the pension
plan’s funded status (FS). The funded status equals the difference between the fair value of plan assets
(FVPA) and pension obligation (PO), so it represents a net amount.
Funded status = Fair value of plan assets − Pension obligation
The FVPA consists of the value of the assets held by the plan, which can be cash or securities. The PO is
the present value of expected future payments to participants pursuant to the DB plan.
Vol 2-35
Learning Module 2
y If PO > FVPA, the plan is said to be underfunded, and a net pension liability equal to the negative
difference is recognized on the balance sheet.
y If PO < FVPA, the plan is said to be overfunded, and a net pension asset equal to the positive
difference is recognized on the balance sheet.
Companies sometimes maintain more than one DB plan. Each plan’s funded status stands on its own;
overfunded plans cannot be netted against underfunded plans to create an overall "net" asset or liability.
This means that a company could report both a pension asset and a pension liability.
On the income statement, the sponsor recognizes an expense each period. Under IFRS, pension expense
has the following three components, two of which are recognized on the income statement and one in other
comprehensive income (OCI):
y Service cost is an operating expense on the income statement. Current service costs refer to the
increase in the pension obligation (present value of promised benefits) due to an employee’s service
in the current period. Each additional year of service increases the amount of the annual pension
payment that the company would owe to the employee upon her retirement, and therefore also
increases the total present value of promised payments (ie, the pension obligation).
Past service costs (PSC) refer to the increase in the pension obligation from retroactive benefits given
to employees for years of service provided before the date of adoption, amendment, or curtailment
of the plan.
y Net interest expense/income is the increase for the period to the accrued interest on the net pension
assets or liabilities.
y Remeasurement applies to the net pension liability or asset. It includes differences between the
actual return on plan assets and the amount assumed in the net interest expense/income calculation
and actuarial gains/losses, which arise from changes in assumptions such as salary increases,
discount rates, and mortality rates. Remeasurement is the component included in OCI, rather than the
income statement.
US GAAP and IFRS Differences in DB Pension Accounting

IFRS and US GAAP treat FVPA and PO reporting identically, but there are differences with respect to
pension expense reporting. US GAAP recognize five components to pension expense:
y Current service costs, which are the same as under IFRS.

y Interest cost, which is reported on a gross basis, rather than net (as under IFRS).
y Expected return on plan assets, which is management’s estimate of what it thinks the return on plan
assets will be.
y Amortization of past service costs. US GAAP require sponsors to report PSC in OCI for the period
in which the change giving rise to the PSC occurs. PSC is amortized to the income statement over the
remaining service lives of participants.
y Amortization of net gains or losses. Actuarial gains/losses and differences between actual and
expected returns on assets can be reported on the income statement. However, it is more common
for them to be reported in OCI, where they are amortized to the income statement using the
"corridor approach."
Vol 2-36
Disclosures for Post-Employment Benefit Plans

There are minimal requirements for disclosures related to DB plans. IFRS only require sponsors to
disclose the amount recognized as an expense. For an OPEB, however, required disclosures include the
characteristics and risks of the plan, a description of the amounts in the financial statements related to the
plan, and the effects of the plan on the sponsor’s cash flows.
Pension reporting for DB plans involves a significant amount of discretion by management with respect to
estimates. This means that analysts must check the disclosures and determine whether they are realistic,
as adjustments may be necessary.
Financial Modeling and Valuation Considerations for

Post-Employment Benefits
LOS: Explain financial modeling and valuation considerations for post-employment benefits.
For DC plans, financial modeling is straightforward and typically related to forecasts of operating expense.
This process tends to work well since DC contributions are based on a percentage of salaries and are
made in cash.
For DB plans, the general approach is to model service costs, remeasurements, net interest expense
(income), and future sponsor contributions. For small DB plans (≤ 5% of the sponsor’s market
capitalization), there may not be much need for detailed forecasts since the pension is relatively immaterial
compared with the company as a whole.
Valuation Considerations for DB Plans

Valuations for DB plans must focus on two considerations:
y the funded status of the plan and

y future service costs (unless the plan is frozen and no further benefits will be accrued).
Underfunded plans are considered as a sponsor liability. Overfunded plans are not typically considered in
valuation, mainly since the plan assets are for the benefit of the participants and are not really "assets" that
the sponsor can generate earnings from.
Future service costs are not included in funded status. Instead, they are future compensation costs that a
participant earns as a substitute for short-term benefits. However, service costs should be deducted from
free cash flow in a discounted cash flow valuation model.
Vol 2-37
Learning Module 2
Vol 2-38
Learning Module 3
Multinational Operations
LOS: Compare and contrast presentation in (reporting) currency, functional currency, and
local currency.
LOS: Describe foreign currency transaction exposure, including accounting for and disclosures
about foreign currency transaction gains and losses.
LOS: Analyze how changes in exchange rates affect the translated sales of the subsidiary and
parent company.
LOS: Compare the current rate method and the temporal method, evaluate how each affects
the parent company's balance sheet and income statement, and determine which method is
appropriate in various scenarios.
LOS: Calculate the translation effects and evaluate the translation of a subsidiary's balance
sheet and income statement into the parent company's presentation currency.
LOS: Analyze how the current rate method and the temporal method affect financial
statements and ratios.
LOS: Analyze how alternative translation methods for subsidiaries operating in hyperinflationary
economies affect financial statements and ratios.
LOS: Describe how multinational operations affect a company's effective tax rate.
LOS: Explain how changes in the components of sales affect the sustainability of sales growth.
LOS: Analyze how currency fluctuations potentially affect financial results, given a company's
countries of operation.
Introduction
LOS: Compare and contrast presentation in (reporting) currency, functional currency, and
local currency.
LOS: Describe foreign currency transaction exposure, including accounting for and disclosure
Most multinational companies engage in two types of foreign currency-related activities that require special
accounting treatment: transactions that are denominated in foreign currencies and investments in foreign
subsidiaries that keep their accounts in foreign currencies.
Vol 2-39
Learning Module 3
Foreign Currency Transactions

In order to report such activities in their consolidated financial statements, multinationals must translate the
related foreign currency amounts into the currency in which they present their financial statements.
y The presentation currency (PC) is the currency used for the parent company's reported financial
statements—typically the currency of the country where the parent is located. For example, US
companies are required to present their financial results in USD, German companies in EUR,
Japanese companies in JPY, and so on.
y The functional currency (FC) is the currency of the primary business environment where an entity
operates, that is, where it primarily generates and expends cash.
y The local currency (LC) is the currency of the country where the subsidiary operates.
Since the local currency is generally the entity's functional currency as well, a multinational parent with
subsidiaries in different countries around the world is likely to have a variety of functional currencies.
Foreign Currency Transaction Exposure to Foreign Exchange Risk

A foreign currency is defined as any currency other than the entity's functional currency. Therefore, foreign
currency transactions are those denominated in a currency other than the company's functional currency.
Foreign currency transactions may involve:
y an import purchase or export sale denominated in a foreign currency, or

y borrowing or lending in which the amount of funds to be repaid or received is denominated in a
foreign currency.
Such transactions give rise to a foreign currency-denominated asset or liability.
Suppose that a US company purchases (imports) goods worth €1 million from a German company, and
it will pay for the goods in EUR within 90 days. By deferring payment, the US company runs the risk that
the EUR will appreciate versus the USD, in which case more USD will be needed to settle the €1 million
obligation. Therefore, the US company is said to have foreign currency transaction exposure.
An importer creates foreign exchange transaction exposure when it defers payment in foreign currency.
The importer faces the risk that the value of the foreign currency will increase between the transaction date
and payment date; in that case, the importer would spend more units of domestic currency to purchase the
required amount of foreign currency when settling the obligation.
An exporter creates foreign exchange transaction exposure when it allows deferred payment in foreign
currency. The exporter faces the risk that the value of the foreign currency will decrease between the
transaction date and payment date; in that case, when payment is made, the exporter would receive fewer
units of domestic currency upon converting the foreign currency amount.
Note that all foreign currency transactions are recorded at the spot exchange rate on the transaction date.
Foreign currency transaction risk arises only when the payment and settlement dates are different.
Both US GAAP and IFRS require that changes in the value of a foreign currency asset/liability resulting
from a foreign currency transaction be recognized as gains/losses on the income statement (Example 1).
The exact amount of gains/losses recognized depends on whether the company has an asset or liability
that is exposed to foreign exchange risk and whether the foreign currency increases or decreases in value
versus the domestic currency.
Vol 2-40
Example 1 Accounting for foreign currency transactions
US Co purchases goods from German Co for €200,000 on Sep 1 20X8 and agrees to make the payment
in EUR in 60 days. US Co's functional and presentation currency is the USD. Spot EUR/USD exchange
rates are:
y Sep 1 20X8: 1.3805

y Oct 31 20X8: 1.4025
Given that US Co's accounting year ends on Dec 31, how will this foreign currency transaction affect the
company's financial statements?
Solution
US Co prepares its accounts in USD. On the transaction date (Sep 1 20X8), US Co recognizes a liability
of $276,100 since, if the payment were not deferred, US Co could settle the transaction by purchasing
and delivering €200,000 to German Co at the then-current spot exchange rate (USD/EUR 1.3805). In
other words, US Co would be purchasing €200,000 for $276,100 (= €200,000 × USD/EUR 1.3805) on the
transaction date.
However, US Co settles the obligation 60 days after the transaction date. In the period between the
transaction and settlement dates, the EUR has appreciated relative to the USD. US Co actually ends up
paying $280,500 (= €200,000 × USD/EUR 1.4025) to purchase €200,000 on Oct 31. By deferring the
payment, US Co incurs a loss of $4,400 (calculated as $280,500 − $276,100) on the transaction. This is
a realized loss (ie, the company paid $4,400 more than the original obligation it recognized on its USD-
denominated financial statements), which is reported on US Co's 20X8 income statement.
In Example 1, the transaction date and payment date occurred in the same reporting period (20X8). If the
balance sheet date occurs between the transaction date and payment date:
y Foreign exchange gains/losses (based on changes in the exchange rate between the transaction date
and balance sheet date) are still recognized on the income statement (even though they have not been
realized) for the period in which the transaction occurred.
y Once the transaction is paid, additional gains/losses are recognized in the period of the payment,
based on changes in the exchange rate between the balance sheet date and settlement date.
y Aggregating the foreign exchange gains/losses over the two accounting periods results in an amount
equal to the actual realized gain/loss on the foreign exchange transaction (Example 2).
Vol 2-41
Learning Module 3
Example 2 Accounting for foreign currency transactions with intervening

balance sheet dates
US Co exports goods worth £15,000 to UK Co on Nov 30 20X8 and agrees to be paid in GBP on Jan
31 20X9. US Co's functional and presentation currency is the USD. USD/GBP spot exchange rates are
as follows:
y Nov 30 20X8: 1.5054

y Dec 31 20X8: 1.5386
y Jan 31 20X9: 1.4975
Given that US Co's accounting year ends on Dec 31, how will this foreign currency transaction affect its
financial statements?
Solution
On Nov 30 20X8, US Co will recognize an asset (receivable) worth $22,581 (= £15,000 × USD/GBP
1.5054 = $22,581). This amount represents the USD value of the receivable based on the spot exchange
rate on the transaction date.
The company's year end is Dec 31, which falls between the transaction date and the settlement date.
Therefore:
y On its 20X8 financial statements, the company is required to recognize (unrealized) foreign
exchange gains/losses based on the change in the USD-denominated value of the receivable due to
changes in the exchange rate between the transaction date and balance sheet date.
○ The value of the receivable rises to $23,079 (calculated as £15,000 × USD/GBP 1.5386) on
Dec 31 20X8.
○ Therefore, US Co recognizes an unrealized gain of $23,079 − $22,581 = $498 on its income
statement for 20X8.
y Since the transaction is settled in 20X9, the company is required to recognize foreign exchange gains/
losses on its 20X9 financial statements, based on the change in the USD-denominated value of the
receivable due to changes in the exchange rate between the balance sheet date and payment date.
○ The value of the receivable falls to $22,462.50 (= £15,000 × USD/GBP 1.4975) on Jan 31 20X9.
○ Therefore, US Co recognizes a loss of $23,079 − $22,462.50 = $616.50 on its income
statement for 20X9.
y US Co recognizes an aggregate foreign currency loss over the two accounting periods
(20X8–20X9), equal to $498 − $616.50 = −$118.50.
○ Overall gain (loss) could also be calculated as the difference between the USD-denominated
value of the receivable on the payment date and the USD-denominated value of the receivable on
the transaction date—in this case, $22,462.50 − $22,581 = −$118.50.
In Example 1, US Co had a liability exposure (in the form of an account payable) to foreign exchange risk.
The foreign currency (EUR) then appreciated, so US Co recognized a loss as the USD-denominated value
of its liability increased.
In Example 2, US Co had an asset exposure (in the form of an account receivable) to foreign exchange risk.
The foreign currency (GBP) appreciated (between the transaction date and balance sheet date), so US Co
recognized a gain as the USD-denominated value of its asset increased. The foreign currency (GBP) then
depreciated (between the balance sheet date and payment date), so US Co recognized a loss as the USD-
denominated value of its asset decreased.
Vol 2-42
Exhibit 1 summarizes how the nature of a company's exposure to exchange rate risk and the direction
of change in the value of the foreign currency impact the foreign exchange gain or loss recognized by
the company.
Exhibit 1 Transaction exposure to currency risk
Foreign currency
Transaction Type of exposure Strengthens Weakens
Exporter Asset (account receivable) Gain Loss

Importer Liability (account payable) Loss Gain
© CFA Institute
Analytical Issues
Both IFRS and US GAAP require foreign exchange transaction gains/losses to be recognized on the
income statement, whether or not they have been realized. However, neither set of standards specifies
where on the income statement these gains/losses must be presented. Companies usually report
foreign exchange transaction gains/losses as a component of either other operating income/expense
or nonoperating income/expense. This reporting choice can have a substantial impact on the reported
operating profit margin.
If a foreign currency transaction gain (loss) is recognized as operating, the operating profit margin would
be greater (less) than it would be if the transaction gain (loss) were recognized as a part of nonoperating
income. Note that the placement of the foreign currency transaction gain/loss (under other operating
income/expense versus nonoperating income/expense) has no impact on the gross profit and net
profit margins.
Another analytical issue related to foreign currency transaction gains/losses is that the eventual translation
gain/loss recognized can be significantly different from the initial recognized amount if the balance sheet
date lies between the transaction and payment dates. For instance, in Example 2, the foreign currency
transaction gain recognized in 20X8 ($498) does not accurately reflect the loss that was ultimately realized
in 20X9 ($118.50).
Disclosures Relating to Foreign Currency Transaction Gains

and Losses
LOS: Describe foreign currency transaction exposure, including accounting for and disclosures
IFRS and US GAAP require disclosure of the aggregate amount of foreign currency transaction gains and
losses included in net income for the period, but do not require disclosure of whether they are classified
as other operating or nonoperating income/expenses. Further, there is no specific guidance regarding the
exact line item in which these gains/losses are included.
Vol 2-43
Learning Module 3
Translation of Foreign Currency Financial Statements
Translation Conceptual Issues

Two issues arise when translating foreign currency results into the parent's presentation currency:
y Choosing the appropriate exchange rate

y Reporting any adjustments to the parent's financial statements due to the translation
To choose the appropriate exchange rate, a parent company can use the current rate method: translate all
the subsidiary's assets and liabilities at the exchange rate in effect on the balance sheet date. Alternatively,
the temporal method can be used: translate only monetary assets and liabilities at the current rate,
and translate nonmonetary assets and liabilities at the rate in effect when those assets or liabilities were
created. Monetary assets and liabilities are items such as receivables (payables) that are translated in a
fixed amount of currency. Nonmonetary assets and liabilities include inventory, fixed assets, intangibles, and
deferred revenue.
Translating assets and liabilities at the current rate results in balance sheet exposure with respect to those
assets. Balance sheet items translated at the rate in effect when the asset or liability was created cause no
balance sheet exposure.
y When more assets than liabilities are translated at the current rate, this causes a net asset balance
sheet exposure. With this type of exposure, if the foreign currency strengthens (weakens), it results in
a positive (negative) translation adjustment to the parent's consolidated balance sheet.
y When more liabilities than assets are translated at the current rate, this causes a net liability balance
sheet exposure. With this type of exposure, if the foreign currency strengthens (weakens), it results in
a negative (positive) translation adjustment to the parent's consolidated balance sheet.
Exhibit 2 summarizes the relationship between the trend in the exchange rate, balance sheet exposure, and
the current period translation adjustment:
Exhibit 2 Balance sheet exposure
Foreign currency
Balance sheet exposure Strengthens Weakens
Net asset Positive translation adjustment Negative translation adjustment

Net liability Negative translation adjustment Positive translation adjustment
© CFA Institute
Vol 2-44
Translation Methods
LOS: Compare the current rate method and the temporal method, evaluate how each affects
the parent company's balance sheet and income statement, and determine which method is
appropriate in various scenarios.
As noted, there are two approaches to translating foreign currency financial statements.
The current rate method (also known as the all-current method) is used to translate financial statements
presented in the functional currency (FC) into amounts expressed in the parent's presentation currency
(PC). Under this method, all assets and liabilities are translated at the exchange rate in effect at the
balance sheet date.
The temporal method (also known as remeasurement) is used to translate financial statements presented
in local currency (LC) into amounts expressed in the FC. Under this method, only monetary assets and
liabilities are translated at the current rate. However, nonmonetary assets and liabilities are also translated
at the current rate if the subsidiary holds them on its balance sheet at their current values.
In each particular situation, the translation method applied depends on the subsidiary's FC. A foreign entity's
FC is defined as the currency of the primary economic environment in which the entity operates. The FC
can be the parent's PC or another currency, typically the currency of the country where the subsidiary is
located (its LC).
The FC is determined by management. According to IFRS (US GAAP offer similar guidance), when making
this determination, management should consider the following factors:
y The currency that influences sales prices of the entity's goods and services
y The currency of the country whose competitive forces and regulations primarily determine the sales
price of those goods and services
y The currency that primarily influences labor, material, and other costs of providing the goods
and services
y The currency in which funds from financing activities are generated
y The currency in which receipts from operating activities are usually retained
Once the FC is identified, the appropriate translation method can be determined.
Exhibit 3 Appropriate translation methods
Translation method
LC = FC PC Current rate
LC FC = PC Temporal
If the LC is deemed to be the FC (LC = FC ≠ PC), the current rate method is used to translate foreign
(ie, local and functional) currency financial statements into the parent's PC. Such instances usually arise
when the subsidiary is independent and its operating, investing, and financing activities are decentralized
from the parent.
Vol 2-45
Learning Module 3
If the subsidiary's PC is deemed to be its FC (LC ≠ FC = PC), the temporal method is used to translate
foreign (ie, local) currency financial statements into the parent's PC. Such instances usually arise when the
subsidiary and parent are well integrated.
Note the following exchange rate definitions:
y The current rate is the exchange rate that exists on the balance sheet date.
y The average rate is the average exchange rate over the reporting period.
y The historical rate is the exchange rate that existed on the original transaction date.
The Current Rate Method

The theory behind the current rate method is that the entire investment in the subsidiary is exposed to
translation gain or loss. Any translation gain or loss, however, is unrealized; it will be realized only when the
subsidiary is sold. Therefore, the net translation gain or loss is reported as a separate component of the
parent's owners' equity.
The current rate method nearly always results in a net asset balance sheet exposure since assets are
generally greater than liabilities. The current rate method is applied as shown in Exhibit 4.
Exhibit 4 Translation steps when using current rate method
Start with income Next: translate

Translation adjustment
statement balance sheet
y Translate items at y Translate balance y Translation adjustment

appropriate rates sheet items at is "plug" figure to keep
appropriate rates balance sheet in balance
y Transfer retained
earnings to y Adjustment is recorded as
balance sheet separate component of
owners' equity, not as part
of consolidated income
y The income statement and statement of retained earnings are translated first, at the historical rate
(which, for practical purposes, is assumed to equal the average rate).
y All balance sheet accounts (except common equity) are translated at the current rate.
y Capital stock is translated at the historical rate that existed on the date of capital contribution.
y Dividends are translated at the rate that applied when they were declared.
y The translation gain/loss for the period is the balancing amount. It is included in shareholders' equity
under the cumulative translation adjustment (CTA).
The Temporal Method

The temporal method is applied as shown in Exhibit 5.
Vol 2-46
Exhibit 5 Translation steps when using temporal method
Next: translate income

Start with balance sheet Translation adjustment
statement
y Translate everything at y Translate income y Translation gain/loss

appropriate rates except statement categories at forces retained earnings
retained earnings appropriate rates on income statement to
equal balance sheet's
y Retained earnings are y Change in retained
retained earnings
"plug" that balances earnings from balance
balance sheet sheet is amount of y Gain/loss factors into
periodic retained earnings consolidated net income
from income statement
y Monetary assets and monetary liabilities are translated at the current rate.
y Nonmonetary assets and liabilities measured at historical cost are translated at historical rates.
y Nonmonetary assets and liabilities measured at current value are translated at the exchange rate that
existed when current value was determined. Nonmonetary assets measured at current cost include
marketable securities and inventory measured at market under the lower of cost or market rule.
y Shareholders' equity accounts are translated at historical rates.
y Revenues and expenses (other than expenses related to nonmonetary assets) are translated at the
average rate.
y Expenses related to nonmonetary assets (eg, COGS, depreciation, amortization) are translated at the
historical rates prevailing at the time the related nonmonetary assets were purchased.
The translation gain/loss (ie, remeasurement gain/loss) is reported on the income statement. It is the plug
figure that would make net income for the year consistent with ending retained earnings (after accounting
for dividends) from the translated balance sheet. Under both US GAAP and IFRS, when using the temporal
method, the translation adjustment needed to keep the balance sheet in balance is reported as a current
gain or loss on the income statement.
Note that the historical exchange rate used to translate inventory and COGS under the temporal method
will differ according to the cost flow assumption (FIFO, LIFO, average cost) used. If FIFO (LIFO) is used,
ending inventory consists of recent (old) purchases, so inventory will be translated at relatively recent (old)
exchange rates, while COGS will be translated at relatively old (new) exchange rates.
Under the temporal method, most liabilities are monetary, while only cash and receivables are monetary
assets. This means that in most cases, there will be a net liability balance sheet exposure, in contrast to the
current rate method, under which there will almost always be a net asset balance sheet exposure.
Vol 2-47
Learning Module 3
Example 3 Foreign currency translation
Alpha Ltd. is headquartered in the United States and prepares its consolidated financial statements in
USD. The company has a subsidiary, Beta Ltd., which is based in Spain. Beta Ltd.'s financial statements
for 20X0 (its first year of operations) are provided below:
Income Statement and Statement of Retained Earnings
For the year ended Dec 31 20X0
EUR 20X0
Sales 14,500,000
Cost of sales 10,000,000
Selling expenses 950,000
Depreciation expense 200,000
Interest expense 415,000
Income taxes 850,000
Net income 2,085,000
Less: Dividends 800,000
Retained earnings 1,285,000
Balance Sheet
As of Dec 31 20X0
EUR 20X0
Cash 1,020,000
Accounts receivable 970,000
Inventory 1,400,000
Total current assets 3,390,000
Property, plant, and equipment 4,000,000
Less: Accumulated
200,000
depreciation
Accounts payable 405,000
Total current liabilities 405,000
Long-term notes payable 3,500,000
Capital stock 2,000,000
Retained earnings 1,285,000
Total equity 3,285,000
Total liabilities and equity 7,190,000
Vol 2-48
For the purpose of translating Beta's financial statements into USD, the following exchange rates are
given. Note that the EUR has depreciated against the USD over the year.
Date USD/EUR
Jan 1 20X0 1.35

Average, 20X0 1.325
Weighted average rate when inventory was acquired 1.32
Dec 1 20X0 (when dividends were declared) 1.31
Dec 31 20X0 1.30
Translate Beta's financial statements into the parent's presentation currency (ie, USD) using the current
rate method.
Translate Beta's financial statements into the parent's presentation currency (ie, USD) using the
temporal method.
Solution
Current rate method
1. Under the current rate method, we first translate all income statement items to derive net income
and retained earnings.
Income Statement and Statement of Retained Earnings 20X0
Current rate method
€ Rate used $
Sales 14,500,000 1.325 (A) 19,212,500

Cost of sales 10,000,000 1.325 (A) 13,250,000
Selling expenses 950,000 1.325 (A) 1,258,750
Depreciation expense 200,000 1.325 (A) 265,000
Interest expense 415,000 1.325 (A) 549,875
Income taxes 850,000 1.325 (A) 1,126,250
Net income 2,085,000 2,762,625
Less: Dividends 800,000 1.31 (H) 1,048,000
Change in retained earnings 1,285,000 1,714,625
Change in retained earnings = Net income − Dividends = 2,762,625 − 1,048,000 = $1,714,625
Vol 2-49
Learning Module 3
2. Next, translate the balance sheet. Use net income (from the translated income statement) to
compute retained earnings and the translation adjustment for the balance sheet.
Balance Sheet
As of Dec 31 20X0
Current rate method
€ Rate used $
Cash 1,020,000 1.30 (C) 1,326,000

Accounts receivable 970,000 1.30 (C) 1,261,000
Inventory 1,400,000 1.30 (C) 1,820,000
Total current assets 3,390,000 4,407,000
Property, plant, and equipment 4,000,000 1.30 (C) 5,200,000
Less: Accumulated depreciation 200,000 1.30 (C) 260,000
Total assets 7,190,000 9,347,000
Accounts payable 405,000 1.30 (C) 526,500
Total current liabilities 405,000 526,500
Long-term notes payable 3,500,000 1.30 (C) 4,550,000
Total liabilities 3,905,000 5,076,500
Capital stock 2,000,000 1.35 (H) 2,700,000
Retained earnings 1,285,000 From I/S 1,714,625
Cumulative translation adjustment −144,125
Total equity 3,285,000 4,270,500
Total liabilities and equity 7,190,000 9,347,000
The cumulative translation adjustment (CTA) on the balance sheet is the plug figure that makes the
accounting equation balance.
y Total assets equal $9,347,000. Liabilities plus shareholders' equity must also add up to $9,347,000.
y Given that total liabilities amount to $5,076,500, total equity must equal $4,270,500
(calculated as 9,347,000 − 5,076,500).
y Therefore:
Capital stock + Retained earnings + CTA = $4,270,500

CTA = 4,270,500 − 2,700,000 − 1,714,625 = ($144,125)
Translation gain (loss) = ($144,125)
An important point here is that, since this is Beta's first year of operations, retained earnings on the
balance sheet is net income for the year adjusted for dividends declared (as there are no retained
earnings brought forward from previous years). Similarly, the entire amount of the CTA on the balance
sheet reflects the translation gain/loss for the current year (as there are no translation gains/losses
brought forward from previous years). If this were not the first year of Beta's operations, the change
in retained earnings over the year would be added to beginning retained earnings to compute ending
retained earnings (which is used in the computation of the CTA).
Vol 2-50
Further, look at the change in the CTA over the year to identify the translation gain (loss) for the current
year. An increase in the positive value (or a decrease in the negative value) of the CTA would indicate a
translation gain for the period.
Temporal method
1. Under the temporal method, first translate the balance sheet to determine the change in retained
earnings over the period.
Balance sheet
Temporal method
€ Rate used $
Cash 1,020,000 1.30 (C) 1,326,000

Accounts receivable 970,000 1.30 (C) 1,261,000
Inventory 1,400,000 1.32 (H) 1,848,000
Total current assets 3,390,000 4,435,000
Property, plant, and equipment 4,000,000 1.35 (H) 5,400,000
Less: Accumulated
200,000 1.35 (H) 270,000
depreciation
Total assets 7,190,000 9,565,000
Accounts payable 405,000 1.30 (C) 526,500
Total current liabilities 405,000 526,500
Long-term notes payable 3,500,000 1.30 (C) 4,550,000
Total liabilities 3,905,000 5,076,500
Capital stock 2,000,000 1.35 (H) 2,700,000
Retained earnings 1,285,000 1,788,500
Total equity 3,285,000 4,488,500
Total liabilities and equity 7,190,000 9,565,000
Retained earnings = Total assets − Liabilities − Common stock

= 9,565,000 − 5,076,500 − 2,700,000 = $1,788,500
Vol 2-51
Learning Module 3
2. On the income statement, the change in retained earnings (from the translated balance sheet) is
used to determine net income for the year and the translation gain/loss.
Income Statement and Statement of Retained Earnings
Temporal method
€ Rate used $
Sales 14,500,000 1.325 (A) 19,212,500

Cost of sales 10,000,000 1.32 (H) 13,200,000
Selling expenses 950,000 1.325 (A) 1,258,750
Depreciation expense 200,000 1.35 (H) 270,000
Interest expense 415,000 1.325 (A) 549,875
Income tax 850,000 1.325 (A) 1,126,250
Income before translation gain (loss) 2,085,000 2,807,625
Translation gain (loss) N/A 28,875
Net income 2,085,000 2,836,500
Less: Dividends 800,000 1.31 (H) 1,048,000
Change in retained earnings 1,285,000 1,788,500
Net income = Change in retained earnings + Dividends declared for the year
= 1,788,500 + 1,048,000 = $2,836,500
As this is Beta's first year of operations, the entire amount of retained earnings adjusted for dividends
declared equals net income for the year (ie, the change in retained earnings equals year-end
retained earnings).
Translation gain (loss) = Net income − Income before translation gain/loss

= 2,836,500 − 2,807,625 = $28,875
Vol 2-52
Example 4 Calculating the cumulative translation adjustment under the current rate method
An analyst gathered the following information regarding a company:
y Retained earnings on Jan 1 20X0 = $550,000

y Cumulative translation adjustment (CTA) on Jan 1 20X0 = $65,000
y Net income for 20X0 = $1,150,000
y Dividends declared on Dec 31 20X0 = $690,000
y Total assets on Dec 31 20X0 = $6,575,000
y Total liabilities on Dec 31 20X0 = $3,485,000
y Common stock = $2,000,000
Calculate the ending balance of the CTA and translation gain for the period.
Solution
Retained earnings at the end of the year equals beginning retained earnings plus net income for the year
minus dividends declared.
Retained earnings on Dec 31 20X0 = 550,000 + 1,150,000 − 690,000 = $1,010,000.
The ending value of the CTA is the amount that must be plugged into the year-end balance sheet to
confirm that the accounting equation holds (ie, the balance sheet balances).
Ending CTA = Total assets − Total liabilities − Common stock − Retained earnings
= 6,575,000 − 3,485,000 − 2,000,000 − 1,010,000 = $80,000
The translation gain/loss over the period is measured as the change in CTA over the year. The positive
change in the CTA indicates that there was a translation gain over 20X0.
Translation gain for the period = 80,000 − 65,000 = $15,000
Translation Analytical Issues
The use of different methods of translation with different exchange rates applied obviously produces
different financial statements, which impacts the financial statement analysis and ratios. Exchange rate
changes will further complicate the analysis. Exhibit 6 summarizes some of the differences and their effects.
Vol 2-53
Learning Module 3
Exhibit 6 Effects of exchange rate movements on financial statements
Temporal method, net Temporal method, net

Current rate method
monetary liability exposure monetary asset exposure
↑ Revenues ↑ Revenues ↑ Revenues
Foreign ↑ Assets ↑ Assets ↑ Assets

currency
strengthens ↑ Liabilities ↑ Liabilities ↑ Liabilities
relative to ↓ Net income ↑ Net income ↑ Net income
parent's
presentation ↓ Shareholders' equity ↑ Shareholders' equity ↑ Shareholders' equity
currency
Translation loss Translation gain Positive translation
adjustment
↓ Revenues ↓ Revenues ↓ Revenues
Foreign ↓ Assets ↓ Assets ↓ Assets

currency
weakens ↓ Liabilities ↓ Liabilities ↓ Liabilities
relative to ↑ Net income ↓ Net income ↓ Net income
parent's
presentation ↑ Shareholders' equity ↓ Shareholders' equity ↓ Shareholders' equity
currency
Translation gain Translation loss Negative translation
adjustment
© CFA Institute
Translation in a Hyperinflationary Economy
LOS: Analyze how alternative translation methods for subsidiaries operating in hyperinflationary
economies affect financial statements and ratios.
In an economy that is experiencing high inflation, the local currency loses purchasing power within the local
economy and tends to depreciate relative to other currencies. As the currency loses value, the historical
cost of fixed assets such as PPE is translated at increasingly lower exchange rates, so the translated value
of those assets diminishes on the parent's balance sheet (ie, the "disappearing plant" problem). However,
the assets' value in local currency would be expected to rise with inflation. IFRS allow the adjustment of
nonmonetary assets and liabilities for inflation, while US GAAP do not.
When a foreign subsidiary is located in a highly inflationary economy and is under US GAAP, the
subsidiary's functional currency is not considered when determining the applicable translation method. The
functional currency is assumed to be the parent's presentation currency, and the temporal method is used
to translate the subsidiary's financial statements. The translation gain/loss is included in net income.
Vol 2-54
Under IFRS, the subsidiary's foreign currency accounts are restated for inflation and then translated into the
parent's presentation currency using the current exchange rate:
y Nonmonetary assets and liabilities are restated for changes in the general purchasing power of the
local currency.
○ Nonmonetary items carried at historical cost are restated for inflation by multiplying their values by
the change in the general price index from the date of acquisition to the balance sheet date.
○ Nonmonetary items carried at revalued amounts are restated for inflation by multiplying their
revised values by the change in the general price index from the date of revaluation to the
balance sheet date.
y Monetary assets and liabilities (eg, cash, receivables, payables) are not restated for inflation.
y Shareholders' equity accounts are restated for inflation by multiplying their values by the change in
the general price index from the beginning of the period (or the date of contribution, if later) to the
balance sheet date.
y Income statement items are restated for inflation by multiplying their values by the change in the
general price index from the dates when the items were originally recorded to the balance sheet date.
y All items are then translated into the parent's presentation currency using the current exchange rate.
y The gain/loss in purchasing power is recorded on the income statement.
Purchasing power gains and losses from inflation are similar to translation gains and losses from
depreciation of the foreign currency when the temporal method is applied. A net monetary liability exposure
combined with hyperinflation gives rise to purchasing power gains. A net monetary liability exposure
combined with foreign currency depreciation gives rise to translation gains.
Under the temporal method, a company's net monetary asset (liability) position is exposed to inflation
risk since monetary assets and liabilities are not restated for inflation. In an inflationary environment,
borrowers—who have payables—gain while lenders lose out since they hold receivables. Therefore, a
company will recognize a purchasing power gain (loss) if it holds more monetary liabilities (assets) than
monetary assets (liabilities). See Example 5.
Vol 2-55
Learning Module 3
Example 5 Foreign subsidiary operating in a hyperinflationary environment
Mercury Inc. formed a subsidiary in a foreign country on Jan 1 20X0. Selected financial statement
information regarding the subsidiary in units of the foreign currency (FC) is provided below:
Income Statement 20X0 (FC)
Revenue 1,500
Interest expense 550
Net income 950
Balance Sheet Jan 1 20X0 (FC) Dec 31 20X0 (FC)
Cash 1,000 1,950

Fixed assets 9,000 9,000
Total assets 10,000 10,950
Notes payable 5,000 5,000
Capital stock 5,000 5,000
Retained earnings 0 950
Total liabilities and equity 10,000 10,950
The foreign country experienced significant inflation during 20X0. The general price index (GPI) during
20X0 was:
Date GPI
Jan 1 20X0 100

Average, 20X0 160
Dec 31 20X0 200
Due to the high inflation rate, the foreign currency depreciated significantly during 20X0. The following
table shows the exchange rate between the USD (Mercury's presentation currency) and FC:
Date USD/FC
Jan 1 20X0 1.400

Average, 20X0 0.875
Dec 31 20X0 0.700
Translate the foreign subsidiary's financial statements into the parent's presentation currency based
on IFRS and US GAAP, assuming that the foreign country falls under the definition of a highly
inflationary economy.
Vol 2-56
Solution
IFRS
y Nonmonetary items are restated for inflation (by applying the change in GPI since the date of
acquisition) and then translated into USD at the current exchange rate.
y Monetary items are not restated for inflation and are translated into USD at the current exchange rate.
Restatement Inflation- Exchange

Balance Sheet FC factor adjusted FC rate USD
Cash 1,950 N/A 1,950 0.70 (C) 1,365

Fixed assets 9,000 200 / 100 18,000 0.70 (C) 12,600
Total 10,950 19,950 13,965
Notes payable 5,000 N/A 5,000 0.70 (C) 3,500
Capital stock 5,000 200 / 100 10,000 0.70 (C) 7,000
Retained earnings 950 4,950 0.70 (C) 3,465
Total 10,950 19,950 13,965
The inflation-adjusted value of total assets is FC 19,950. Given inflation-adjusted notes payable and capital
stock of FC 5,000 and FC 10,000, respectively, inflation-adjusted retained earnings amount to FC 4,950.
Inflation-adjusted retained earnings are then used to compute the purchasing power gain (loss) on the
income statement. Income statement items are restated for inflation (by applying the change in GPI from
the average GPI over the period) and then translated into USD at the current exchange rate.
Restatement Inflation- Exchange

Income Statement FC factor adjusted FC rate USD
Revenue 1,500 200 / 160 1,875.00 0.70 (C) 1,312.50

Interest expense 550 200 / 160 687.50 0.70 (C) 481.25
Subtotal 950 1,187.50 831.25
Purchasing power gain/loss 3,762.50 0.70 (C) 2,633.75
Net income 4,950.00 3,465.00
Given inflation-adjusted retained earnings of FC 4,950 and inflation-adjusted revenues and expenses
of FC 1,875 and FC 687.50, respectively, the purchasing power gain (loss) equals FC 3,762.50 or
USD 2,633.75.
The net purchasing power gain of FC 3,762.50 can be explained as follows:
y Gain from having notes payable:

○ FC 5,000 × (200 − 100) / 100 = FC 5,000
y Loss from holding beginning cash balance:
○ −FC 1,000 × (200 − 100) / 100 = −FC 1,000
y Loss from increase in cash over the year:
○ −FC 950 × (200 − 160) / 160 = −FC 237.50

y Net purchasing power gain (loss) = 5,000 − 1,000 − 237.50 = FC 3,762.50
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Learning Module 3
Note that under this method, all FC amounts (adjusted for inflation where required) are translated at
the current exchange rate, so there is no exposure to exchange rate risk. Therefore, no translation
adjustment is required.
US GAAP
The temporal method is used to translate the foreign subsidiary's financial statements into the parent's
presentation currency:
Balance Sheet
FC Exchange rate USD
Cash 1,950 0.70 (C) 1,365

Fixed assets 9,000 1.40 (H) 12,600
Total assets 10,950 13,965
Notes payable 5,000 0.70 (C) 3,500
Capital stock 5,000 1.40 (H) 7,000
Retained earnings (balancing figure) 950 3,465
Total liabilities and equity 10,950 13,965
The translation gain (loss) appears on the income statement:
Income Statement
FC Exchange rate USD
Revenue 1,500 0.875 (A) 1,312.50

Interest expense 550 0.875 (A) 481.25
Subtotal 950 831.25
Translation gain/loss 2,633.75
Net income 3,465.00
Since this is the subsidiary's first year of operations, the entire amount of retained earnings is attributable
to the current year's net income (dividends declared equal 0).
Note that in this example, the purchasing power gain calculated under IFRS is the same as the
translation gain calculated under US GAAP (USD 2,633.75). This is not always the case. However, in the
given scenario, there is an exact one-to-one inverse relationship between the change in the GPI in the
foreign country and the value of the FC relative to the USD, which results in equal purchasing power and
translation gains.
y The GPI doubled, so the FC lost half its purchasing power.

y The dollar value of the FC also halved (from USD/FC 1.40 to USD/FC 0.70)
Vol 2-58
Using Both Translation Methods
Disclosures Related to Translation Methods

Under both IFRS and US GAAP, companies are required to disclose:
y The total amount of exchange differences (ie, transaction and translation gains and losses), recognized
in net income. Companies are not required to separate transaction gains/losses from those related to
translation on the income statement.
y The total amount of cumulative translation adjustment, classified as a separate component of
shareholders' equity, as well as a reconciliation of the amount of cumulative translation adjustment at
the beginning and end of the period.
Disclosures related to foreign currency translation are typically found in the sections of the annual report for
management discussion and analysis (MD&A) and notes to the financial statements.
Multinational companies generally have several subsidiaries in different regions, so the translation gain/loss
on the income statement and cumulative translation adjustment on the balance sheet include the effects of
translation of foreign currency accounts for all the parent's subsidiaries. Disclosures related to the parent's
exposures to individual currencies are limited.
Due to the judgments involved when determining the functional currency, two companies operating within
the same industry may use different predominant translation methods. In that situation, net income reported
by the companies would not be directly comparable. In order to facilitate comparisons across companies,
analysts may add the change in CTA over the year to net income for the year. This adjustment, in which
gains/losses that would be reported directly in equity are instead reported in net income, is known as clean
surplus accounting. However, this adjustment would still not make the two companies truly comparable.
Multinational Operations and a Company's Effective Tax Rate
LOS: Describe how multinational operations affect a company's effective tax rate.
Generally, multinational companies are liable to pay income taxes in the country where their profits are
earned. The allocation of profit across subsidiaries (and countries) is affected by transfer prices (ie, the
prices at which divisions within the company transact with each other). Entities whose operations are
located in multiple countries with different tax rates have an incentive to set transfer prices such that a
greater proportion of profits is allocated to lower tax rate jurisdictions. This has prompted countries to
establish various laws and practices that prevent aggressive transfer pricing.
Most countries are bound by tax treaties that prevent double taxation of corporate profits. For example, in
the United States, multinationals are liable only for a residual tax on foreign income, after applying a credit
for foreign taxes paid on that same income. Therefore, a multinational owes the US government taxes
on foreign income only to the extent that the US corporate tax rate exceeds the foreign rate of tax on that
income. Further, much of the foreign income earned by US multinationals is not taxed until it is repatriated.
Vol 2-59
Learning Module 3
Accounting standards require companies to explain the relationship between tax expense and accounting
profit in a detailed reconciliation between the average effective tax rate (ie, tax expense divided by pretax
accounting profits) and the relevant statutory tax rate. Changes in the impact of foreign taxes on the
parent's effective tax rate can be caused by changes in applicable tax rates and/or changes in the mix of
profits earned in different countries (with different tax rates).
Example 6 Evaluating the impact of foreign taxes on a company's effective tax rate
Below are the extracts from effective tax rate reconciliation disclosures for two hypothetical companies:
ABC Inc. and XYZ Inc.
ABC Inc.
20X2 20X1 20X0
Income tax using the company's domestic tax rate 26% 26.5% 26.5%
Effect of tax rates in foreign jurisdictions 4.5 3.2 2.3
Effect of nondeductible expenses 3 4.2 5
Effect of tax incentives and exempt income (5) (6) (8)
Recognition of previously unrecognized tax losses (1.8) (1) (0.8)
Effect of changes in tax rate 0.3 0.4 0.6
Withholding taxes 2.5 2.2 1.7
Under/(over) provided in prior years (3.1) (4.2) (5.5)
Other reconciling items 0.3 0.6 0.8
26.7% 25.9% 22.6%
XYZ Inc.: Percentage of income before income taxes

20X2 20X1 20X0
Tax at United States statutory rate 32% 32% 32%

State income taxes, net of federal benefit 0.6 2 1.1
Earnings taxed at other than United States statutory rate (2.3) (5) (3.6)
Other, net (2.2) (2.8) (1.5)
Effective tax rate 28.1% 26.2% 28%
Based on the information provided, answer the following questions:
1. Which company's home country has a lower statutory tax rate?

2. What was the impact of multinational operations on each company's effective tax rate for 20X2?
3. What do ABC's disclosures suggest about the geographic mix of its 20X2 profits?
Vol 2-60
Solution
1. ABC's home country's statutory tax rate (26% in 20X2) is lower than XYZ's home country statutory
tax rate (32% in 20X2).
2. The impact of foreign taxes and ABC's multinational operations on its effective tax rate can be
gauged by looking at the line item labeled "Effect of tax rates in foreign jurisdictions." This line item
indicates that multinational operations increased ABC's effective tax rate for 20X2 by 4.5%. For
XYZ, we look at "Earnings taxed at other than United States statutory rate," which indicates that
multinational operations lowered XYZ's effective tax rate by 2.3% in 20X2.
3. Changes of profit mix between countries with higher or lower marginal tax rates result in changes in
the tax rate impact of multinational operations. Multinational operations increased ABC's effective
tax rate by 4.5% in 20X2, but by only 3.2% in 20X1. The more significant impact in 20X2 could
indicate that ABC's profit mix in 20X2 moved to countries with higher statutory tax rates.
Additional Disclosures on the Effects of Foreign Currency
LOS: Explain how changes in the components of sales affect the sustainability of sales growth.
LOS: Analyze how currency fluctuations potentially affect financial results, given a company's
countries of operations.
Disclosures of multinational companies can help analysts better understand the impact of fluctuation in
exchange rates on the company's performance.
Disclosures Related to Sales Growth

Companies often include disclosures related to the impact of exchange rate movements on sales growth
in the MD&A section of the annual report and sometimes in other financial reports, such as company
presentations to investors and earnings announcements. For multinationals, sales growth can be attributed
to changes in:
y price,
y volumes, and/or
y exchange rates.
Sales growth that comes from changes in price and volumes is arguably more sustainable than growth
from exchange rate movements. Therefore, analysts should consider organic sales growth (which excludes
foreign currency effects on sales growth) when forecasting future performance. Also, organic sales growth
is more relevant when evaluating management's performance as management typically has greater control
over changes in volume or price than changes in exchange rates.
Vol 2-61
Learning Module 3
Example 7 Impact of exchange rate movements on sales growth
The table below provides a reconciliation of Torsem Corp's reported sales growth to organic sales growth
(note that the letters for the dates in Column 1 represent the calendar month):
Net sales Foreign Acquisition/divesture Organic

growth exchange impact impact sales growth
OND 20X8 −2% 4% 0% 2%

JFM 20X9 −7% 8% 0% 1%
AMJ 20X9 −10% 8% 1% −1%
JAS 20X9 −5% 7% 0% 2%
Average OND −6% 7% 0% 1%

20X8–JAS 20X9
For the four quarters from Oct 20X8 to Sep 20X9, how did changes in foreign exchange rates affect
Torsem's reported sales growth on average?
Solution
Organic sales grew 1% on average over the period. However, the company reported a decline in net
sales of 6% for the period. This is the result of a 7% negative impact from foreign exchange movements.
Stated differently, if there had been no changes in exchange rates over the period, growth in organic
sales and net sales would have come in at 1%.
Disclosures Related to Major Sources of Foreign Exchange Risk

In order to assist users of financial statements, a multinational may describe the source(s) of its currency
risks and its approach to measuring and managing those risks (usually in MD&A) and present a sensitivity
analysis on the effects of currency fluctuations (usually in the additional disclosures section of the notes).
The level of detail provided varies across companies.
Vol 2-62
Learning Module 4
Analysis of Financial Institutions
LOS: Describe how financial institutions differ from other companies.
LOS: Describe key aspects of financial regulations of financial institutions.
LOS: Explain the CAMELS (capital adequacy, asset quality, management, earnings, liquidity,
and sensitivity) approach to analyzing a bank, including key ratios and its limitations.
LOS: Analyze a bank based on financial statements and other factors.
LOS: Describe other factors to consider in analyzing a bank.
LOS: Describe key ratios and other factors to consider in analyzing an insurance company.
Introduction
LOS: Describe how financial institutions differ from other companies.
LOS: Describe key aspects of financial regulations of financial institutions.
What Makes Financial Institutions Different?

Financial institutions have systemic importance as they are essential to the overall health of markets
and economies. Banks are especially significant because they serve as intermediaries that facilitate
credit between providers and borrowers. The effects can be seen across the household, corporate, and
government sectors.
Due to the increasing interconnectedness of financial institutions around the world in recent decades,
more emphasis has been placed on protecting institutions that are deemed to have systemic importance.
Systemic risk refers to the risk of issues in the financial system disrupting financial services, potentially
leading to severe economic consequences. Financial contagion occurs when the effects of bank failures
spread globally to other sectors and economies, as seen in the 2008 global financial crisis.
Financial institutions are heavily regulated in order to prevent systemically important institutions from taking
excessive risks. The regulations cover various aspects of operations and include reserve requirements,
minimum liquidity levels, and, in some cases, stress tests. Confidence in the banking system is essential
since any failure of banks to honor depositor withdrawals can lead to a bank run, increasing the risk of
contagion across a country's financial system. Financial institutions mostly hold financial assets, such as
securities and loans, that are typically reported at fair value.
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Learning Module 4
Institutions Providing Basic Banking Services

y Commercial banks offer traditional banking services, including deposits, lending, and payments.
y Credit unions, cooperative banks, and mutual banks are similar to commercial banks but are owned by
their members and organized as nonprofits.
y Specialized financial service providers include:
○ Building societies and savings and loan institutions that specialize in offering long-term
residential mortgages.
○ Mortgage banks, which originate, sell, service, and securitize mortgages.
○ Trust banks (prominent in Japan), which offer long-term commercial loans, securities investments,
and "money trusts".
○ Online payment companies.
y Managers of pooled investment vehicles pool investors' money to buy and sell securities via a
fund vehicle.
y Hedge funds pool investors' money and employ more complex strategies, with higher fees and
minimum investment requirements.
y Property and casualty insurers provide coverage related to automobiles, homes, and
commercial activities.
y Life and health insurers provide coverage related to personal planning and medical care.
y Reinsurance companies sell insurance to primary insurers, allowing those insurers to rebalance their
risk exposure.
Global Organizations
In the context of global systemic risk, important differences exist between the banking and insurance
sectors. Insurance companies typically have less cross-border business than banks, though the reinsurance
industry is more international.
The interconnectedness of global financial institutions creates a need for regulatory oversight and poses
challenges. Global and regional regulatory bodies standardize regulatory rules and oversight and minimize the
risk of multinational firms engaging in regulatory arbitrage. The Basel Committee on Banking Supervision,
whose members include central banks and entities responsible for bank supervision worldwide, is one of the
most important global regulatory bodies; it operates with support from the Bank for International Settlements.
Basel III is an international regulatory framework developed by the Basel Committee. Three important
aspects of Basel III are its requirements for a bank's minimum capital, minimum liquidity, and stable funding.
The minimum capital requirement specifies the minimum percentage of a bank's risk-weighted assets
that must be funded with equity capital. This requirement prevents the bank from using excessive financial
leverage such that its ability to tolerate loan losses is critically impaired.
The minimum liquidity requirement specifies that a bank must have enough high-quality liquid assets
to meet its liquidity requirements in a 30-day liquidity stress scenario. This ensures that the bank has
adequate cash in the event that it loses access to some funding sources or must meet off-balance-sheet
funding requirements.
The stable funding requirement specifies the minimum amount of stable funding required to meet a
bank's liquidity needs over a one-year time horizon. Longer maturity deposits are viewed as more stable
than shorter maturity deposits, and consumer deposits are considered more stable than funding from the
interbank market.
Vol 2-64
Individual Jurisdictions' Regulatory Authorities

In collaboration with global organizations, individual jurisdictions' regulatory authorities aim to promote
financial stability by providing direct oversight of financial institutions within the jurisdiction. Some overlap
may occur between regulatory organizations, and, in some cases, the same regulatory body may regulate
both the banking and insurance industries within a country.
Analyzing a Bank: The CAMELS Approach
LOS: Explain the CAMELS (capital adequacy, asset quality, management, earnings, liquidity,
and sensitivity) approach to analyzing a bank, including key ratios and its limitations.
LOS: Analyze a bank based on financial statements and other factors.
The CAMELS Approach

The CAMELS approach can be used to analyze a bank that is primarily involved in taking deposits and
making loans, based on the following six factors:
y Capital adequacy
y Asset quality
y Management capabilities
y Earnings
y Liquidity position
y Sensitivity to market risk
Using this approach, a bank is given a score between 1 and 5 on each factor, as well as an overall score
that combines the bank's scores on each of the individual factors. A score of 1 denotes risk management
best practice and the lowest level of concern for the bank's regulators, while a score of 5 indicates the worst
level of risk management and the highest level of concern for regulators.
Capital Adequacy
Given a bank's systemic importance, it must possess an adequate level of capital so that potential losses do
not lead to financial weakness or failure. Capital adequacy is defined in terms of the percentage of a bank's
risk-weighted assets that must be funded with capital. Risk weightings are specified by the bank's regulators
and are usually based on Basel III guidelines. For example, nonperforming loans have a risk weighting in
excess of 100%, while cash has a risk weighting of zero, so it is excluded from risk-weighted assets and
does not need to be funded with capital. A bank's off-balance-sheet exposures must also be included in risk-
weighted assets.
For capital adequacy purposes, a bank's capital is divided into different tiers (layers), based on the ability to
absorb losses.
Common equity Tier 1 capital includes common stock, any surplus resulting from the issue of that stock,
retained earnings, accumulated other comprehensive income, and certain regulatory adjustments and
deductions applied when calculating those forms of capital.
Other Tier 1 capital includes instruments that meet certain criteria (eg, subordination to bank deposits and
other debt obligations), bear no fixed maturity, and have no requirement to pay dividends or interest that is
not fully at the bank's discretion.
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Learning Module 4
Tier 2 capital includes instruments that are subordinate to bank deposits and general creditors, as well as
portions of the allowance for loan losses.
Basel III also specifies the required minimum capital ratios for a bank:
Exhibit 1 Basel III regulatory capital requirements
Capital ratios Minimum standard
Total common equity Tier 1 capital

Common equity Tier 1 capital ratio = 4.5%
Total risk-weighted assets
Common equity Tier 1 capital + Additional Tier 1 capital

Tier 1 ratio = 6.0%
Total capital
Total capital ratio = 8.0%
Note: A country's bank regulators may decide to apply different minimum capital requirements from those
specified by Basel III to banks under their jurisdiction.
Example 1 Key capital ratios
XYZ Bank has reported the following capital ratios, amount of capital by tier, and risk-weighted assets
by risk types.
Capital ratios 20X2 20X1
Common equity Tier 1 ratio 13.3% 12.4%

Tier 1 ratio 17.2% 15.6%
Total capital ratio 21.5% 19.6%
Regulatory capital 20X2 20X1
Common equity Tier 1 capital 41,565 45,204

Additional Tier 1 capital 12,349 11,764
Tier 2 capital 13,261 14,878
Total regulatory capital 67,175 71,846
Risk-weighted assets 20X2 20X1
Credit risk 190,017 241,540

Counterparty credit risk 35,042 35,693
Market risk 31,314 31,756
Operational risk 56,660 56,660
Total risk-weighted assets 313,033 365,649
Comment on the change in XYZ's capital ratios in 20X2.
Vol 2-66
Solution
All of XYZ's capital ratios improved in 20X2 compared with 20X1. The main reason for the improvement
is that the reduction in total risk-weighted assets in 20X2 (down 14.4%) was larger than the reduction in
common equity Tier 1 capital (down 8.1%), Tier 1 capital (down 5.4%), and total capital (down 6.5%).
Asset Quality
Asset quality reflects the existing and potential credit risk of a bank's financial assets (eg, loans, securities).
Loans are usually the largest proportion of a bank's assets. The loans' asset quality depends on the credit
quality of borrowers and the adequacy of loan loss allowances. Loans are measured at amortized cost, net
of loan loss allowances, while securities are typically measured at amortized cost or fair value, depending
on their IFRS or US GAAP classification. Liquid assets include cash, deposits with banks, and reverse
repurchase agreements as well as similar secured lending agreements.
Example 2 Analysis of asset composition
The breakdown of XYZ Bank's balance sheet assets, reported under IFRS, is shown below.
Balance sheet assets 20X2 20X1
Cash and balances at central banks 171,082 102,353

Items in the course of collection from other banks 2,153 1,467
Trading portfolio assets 113,760 80,240
Financial assets designated at fair value 116,281 78,608
Derivative financial instruments 137,669 246,626
Financial investments 58,916 63,317
Loans and advances to banks 35,663 43,251
Loans and advances to customers 465,552 492,784
Reverse repurchase agreements 12,546 13,454
Assets included in disposal groups classified as held for sale 1,193 71,454
Other assets 18,433 19,572
Total assets 1,133,248 1,213,126
Considering the most liquid assets—cash and balances at central banks and items in the course of
collection from other banks—describe the changes to XYZ's balance sheet liquidity from 20X1 to 20X2.
What is the proportion of investments to total assets in 20X1 and 20X2?
What is the proportion of loans to total assets in 20X1 and 20X2?
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Learning Module 4
Solutions
Balance sheet liquidity in 20X1:
102,353 + 1,467
= 8.6%
1,213,126
Balance sheet liquidity in 20X2:
171,082 + 2,153
= 15.3%
1,133,248
XYZ's balance sheet liquidity increased significantly in 20X2.
XYZ's investments comprised trading portfolio assets, financial assets designated at fair value, derivative
financial instruments, and financial investments.
Proportion of investments to total assets in 20X1:
80,240 + 78,608 + 246,626 + 63,317

= 38.6%
1,213,126
Proportion of investments to total assets in 20X2:
113,760 + 116,281 + 137,669 + 58,916

= 37.6%
1,133,248
XYZ's loans comprised loans and advances to banks and customers, as well as reverse repurchase
agreements.
Proportion of loans to total assets in 20X1:
43,251 + 492,784 + 13,454

= 45.3%
1,213,126
Proportion of loans to total assets in 20X2:
35,663 + 465,552 + 12,546

= 45.3%
1,133,248
When analyzing asset quality in terms of credit quality, key considerations include credit risks associated
with the bank's loan portfolio and investments, trading activities, and off-balance-sheet obligations such as
guarantees and letters of credit. Analysts also consider the bank's diversification of credit risk exposure.
Ratios that can be used to evaluate the quality of the loan loss allowance (from the balance sheet) are the
ratios of loan loss allowance to impaired loans or to actual loan losses. Provision for loan losses (from the
income statement) is the ratio of the loan loss provision to actual loan losses.
Vol 2-68
Example 3 Analysis of asset credit quality
An analyst has produced the following summary of the credit quality of XYZ Bank's assets that are
exposed to credit risk.
Credit quality summary 20X2 20X1
Strong credit quality 923,271 930,324

Neither past due nor impaired Satisfactory credit quality 99,522 127,486
Substandard credit quality 6,856 840
Past due but not impaired 7,679 9,106

Impaired 11,286 12,040
Total gross amount 1,048,614 1,079,796
Impairment allowances (4,342) (4,620)
Total 1,044,272 1,075,176
Did the credit quality of XYZ's assets improve or worsen in 20X2, based on the proportion of assets
invested in instruments with strong credit quality?
Comment on the ratio of impairment allowances to impaired assets in 20X1 and 20X2.
Solutions
Proportion of assets with strong credit quality to gross assets exposed to credit risk in 20X1:
930,324
= 86.2%
1,079,796
Proportion of assets with strong credit quality to gross assets exposed to credit risk in 20X2:
923,271
= 88.0%
1,048,614
The credit quality of XYZ's assets improved in 20X2.
Ratio of impairment allowances to impaired assets in 20X1:
4,620
= 38.4%
12,040
Ratio of impairment allowances to impaired assets in 20X2:
4,342
= 38.5%
11,286
The ratio of impairment allowances to impaired assets remained relatively constant in both years,
indicating that the percentage change in impairment allowances from 20X1 to 20X2 closely reflected the
percentage change in impaired assets over the same period.
Vol 2-69
Learning Module 4
Management Capabilities
The key responsibilities of bank management are:
y Identifying and exploiting profitable business opportunities

y Ensuring compliance with applicable laws and regulations
y Implementing a strong corporate governance framework that includes an independent board and
reduces agency risk
y Identifying and controlling the wide range of risks faced by the bank
The board of directors is responsible for providing guidance on the overall risk appetite of the bank and
ensuring that a risk management program is in place to ensure compliance with risk exposure limits. In line
with the board's guidance, senior management is responsible for developing and implementing effective risk
management procedures that measure and monitor risks.
Earnings
Commercial banks, like other companies, should generate high-quality earnings that provide an acceptable
return on capital. High-quality earnings are value-enhancing, measured by unbiased accounting estimates,
and derived from sustainable activities.
Banks face significant challenges when estimating loan loss allowances for their loan portfolios and valuing
some financial assets and liabilities at fair value. Other key areas requiring accounting estimates include
goodwill impairment and recognition of deferred tax assets.
An analysis of a bank's earnings composition should be performed when assessing earnings sustainability.
The earnings are typically composed of income from net interest, services, and trading.
A bank's net interest income and service income are generally less volatile than its trading income, and
therefore more sustainable. Lower volatility in net interest income may also indicate that the bank is not
excessively exposed to interest rate risk.
Net interest income can be further analyzed by calculating and observing the trend in:
y Interest margin (average interest rate), which is the ratio of interest revenue to average
interest-earning assets
y Average cost of funding, which is the ratio of interest expense to average interest-bearing liabilities
Vol 2-70
Example 4 Analysis of earnings composition
An analyst has extracted the following information on XYZ Bank's operating income.
Operating income 20X2 20X1 20X0
Net interest income 9,845 10,537 10,608

Net fee and commission income 6,814 6,768 6,859
Net trading income 3,500 2,768 3,426
Net investment income 861 1,324 1,097
Other operating income 56 54 50
Total operating income 21,076 21,451 22,040
In 20X2, what percentage of XYZ's total operating income was earned from (a) net interest income, (b)
net fee and commission income, and (c) net trading income?
Comment on the trend in the bank's net interest income and total operating income.
Solutions
A. Percentage of XYZ's total operating income from net interest income:
9,845
= 46.7%
21,076
B. Percentage of XYZ's total operating income from net fee and commission income
6,814
= 32.3%
21,076
C. Percentage of XYZ's total operating income from net trading income
3,500
= 16.6%
21,076
XYZ's net interest income and total operating income have declined year-on-year from 20X0 to 20X2.
The percentage of XYZ's total operating income from net interest income has remained relatively stable
over the same period, around 48%, as shown below.
20X0:
10,608
= 48.1%
22,040
20X1:
10,537
= 49.1%
21,451
20X2:
9,845
= 46.7%
21,076
Vol 2-71
Learning Module 4
Liquidity Position
Bank regulators place a strong emphasis on the liquidity position of banks due to their systemic importance.
Governments often provide limited deposit insurance to protect bank depositors from losses caused by a
bank's inability to honor the deposits.
Basel III has specified two minimum liquidity standards for banks: the liquidity coverage ratio (LCR) and the
net stable funding ratio (NSFR):
y LCR is the ratio of highly liquid assets—cash and assets that can be easily converted into cash—to
the expected (one-month) cash outflows that would be needed in a stress scenario. Basel III sets a
minimum LCR of 100%, ensuring that banks can meet short-term obligations in times of stress.
y NSFR is the ratio of available stable funding to required stable funding. The available stable funding
depends on the composition and maturity of a bank's funding sources (ie, capital, deposits, and other
liabilities), while the required stable funding depends on the composition and maturity of the bank's
asset base. A strong NSFR ensures that a bank's assets and funding sources are appropriately
matched in terms of maturity and stability. Basel III sets a minimum NSFR of 100%, implying that
banks should have at least as much available stable funding as required stable funding.
Basel III has also proposed a number of liquidity-monitoring measures. Two of the more important
measures are concentration of funding (ie, the proportion of funding that is obtained from a single source)
and contractual maturity mismatch, which compares the maturities of a bank's assets and its funding
sources. A maturity mismatch may expose the bank to liquidity risk if cash repayments from borrowers are
insufficient to meet the amount required for maturing deposits.
Example 5 Liquidity analysis
XYZ Bank has disclosed the following liquidity measures in its annual report.
Liquidity measures 20X2 20X1 20X0
Liquidity coverage ratio (LCR) 154% 131% 116%

Net stable funding ratio (NSFR) 120% 117% 115%
How can an analyst interpret the LCR of 154% in 20X2?
Comment on the trend in the bank's NSFR from 20X0 to 20X2.
Solutions
LCR of 154% means XYZ can withstand cash outflows that are 54% higher than its one-month liquidity
needs in a stress scenario. An equivalent interpretation is that XYZ can withstand a stress-level volume
of cash outflows for 46.2 days (154% × 30 days).
XYZ's NSFR has improved each year from 20X0 to 20X2 and comfortably exceeds the 100% minimum
level set by Basel III.
Vol 2-72
Sensitivity to Market Risk

Due to the scope of a bank's activities, its earnings and capital position are exposed to market risk related
to changes in interest rates, equity prices, exchange rates, and commodity prices. A bank's exposure to
market risk may arise from 1) mismatches in maturity, repricing frequency, reference rates, and the currency
of its balance sheet assets and liabilities, and/or 2) off-balance-sheet guarantees and derivatives positions
linked to interest rates, equities, exchange rates, and commodities.
In their annual reports, banks typically provide disclosures related to the tools (eg, interest rate sensitivity
analysis, value-at-risk measures, stress testing) used to manage market risk exposures.
Example 6 Net interest income sensitivity
The following table shows XYZ Bank's sensitivity analysis on pretax net interest income for nontrading
financial assets and liabilities. This metric assumes an instantaneous parallel change to interest rate
forward curves. The main model assumptions are that the time horizon is one year and the balance
sheet is held constant.
Sensitivity analysis on pretax net
interest income for nontrading
financial assets and liabilities
As of Dec 31 20X2 Total
+100 basis points 76

+25 basis points 20
–25 basis points (83)
How would pretax net interest income change if the interest rate forward curves shifted upward by 25
basis points?
Solutions
Pretax net interest income would increase by 20 if the forward curves shifted upward by 25 bps.
Example 7 Value-at-Risk (VaR) Disclosure
XYZ Bank's VaR disclosure for market risk estimates the potential loss arising from unfavorable market
movements if the current positions were held for one business day. A historical simulation methodology
with a two-year, equally weighted historical period at the 95% confidence level is used for all trading
books and banking books exposed to price risk.
The risk factors driving VaR are grouped into key risk types, as shown in the table below. The
diversification effect recognizes that forecasted losses from assets or businesses are unlikely to occur
concurrently. Therefore, the expected aggregate loss is lower than the sum of the expected losses
from each area, and historical correlations between losses are taken into account when making the
assessments. Because the high and low VaR figures reported for each category did not necessarily
occur on the same day as the high and low VaR reported as a whole, a diversification effect balance is
omitted for those figures.
Vol 2-73
Learning Module 4
20X2 20X1
VaR disclosure Average High Low Average High Low
Credit risk 12 18 8 16 24 9
Interest rate risk 8 15 4 7 13 4
Equity risk 8 14 4 7 11 4
Basis risk 5 6 3 5 9 3
Spread risk 5 8 3 3 5 2
Foreign exchange risk 3 7 2 3 5 2
Commodity risk 2 3 1 2 4 1
Inflation risk 2 4 1 2 3 2
Diversification effect (26) n/a n/a (24) n/a n/a
Total VaR 19 26 14 21 29 13
How did XYZ Bank's average total VaR change from 20X1 to 20X2? What was the primary reason for
this change?
Solutions
XYZ's average total VaR declined from 21 in 20X1 to 19 in 20X2, mainly due to a decline in VaR
associated with credit risk from 16 in 20X1 to 12 in 20X2.
Note: While XYZ's VaR measure is useful for forecasting the impact of very short-term shocks, it does not deal with
the impact of longer-term market movements.
Overall CAMELS Score

There is some degree of subjectivity involved in the calculation of the overall CAMELS score, not just in
the individual factor ratings but also in the weighting assigned to each factor. For example, a fixed income
analyst may assign higher weights to capital adequacy and liquidity, whereas an equity analyst may choose
to overweight asset quality and earnings. However, the approach to calculating the overall CAMELS score
for a bank is relatively straightforward, as shown in Example 8:
Vol 2-74
Example 8 Overall CAMELS score
A fixed-income analyst has used the CAMELS approach to analyze XYZ Bank, placing twice as much
weighting on capital adequacy and liquidity than on other factors.
CAMELS analysis Rating Weighting Weighted rating
Capital adequacy 1 2 2
Asset quality 2 1 2
Management capabilities 2 1 2
Earnings 2 1 2
Liquidity 1 2 2
Sensitivity to market risk 1 1 1
What is XYZ's overall CAMELS score, assuming equal weighting for all factors?
What is XYZ's overall CAMELS score if the analyst's weightings are used?
Solutions
Assuming equal weighting for all factors, the overall CAMELS score is the arithmetic mean of the
unweighted ratings for each factor.
Overall CAMELS score:
1+2+2+2+1+1
= 1.5
6
The weighted rating can be calculated for each factor, assigning a weighting of 2 to capital adequacy
and liquidity and a weighting of 1 to all other factors, as shown in the table. The overall CAMELS score is
calculated as the sum of the weighted ratings divided by the sum of the weights.
Overall CAMELS score:
2+2+2+2+2+1
= 1.375
2+1+1+1+2+1
Since higher weighting was assigned to factors with the best rating, this score is slightly better than the
score obtained with equal weighting for all factors.
Vol 2-75
Learning Module 4
Analyzing a Bank: Non-CAMELS Factors
LOS: Describe other factors to consider in analyzing a bank.
LOS: Analyze a bank based on financial statements and other factors
Relevant Analytical Considerations Not Addressed by CAMELS

A number of bank-specific economic and structural considerations that may be relevant to the risk appetite
of a bank—such as its government support, mission, and corporate culture—are not analyzed in the
CAMELS approach.
CAMELS also does not address other relevant considerations that would pertain to the corporate analysis
of any company. Such considerations include the competitive environment, segment information, currency
exposure, risk factors, Basel III disclosures, and off-balance-sheet liabilities (eg, operating leases, assets
under management).
Analyzing a Property and Casualty (P&C) Insurance Company
Insurers provide risk management services to individuals, businesses, and governments. Their revenues
come from insurance premiums, which are typically collected at the initiation of insurance coverage, and
from investment income on the float (ie, premiums collected and not yet used to settle claims).
P&C Insurance Companies
Operations: Products and Distribution

The scope of P&C insurance companies includes insurance for automobiles, homes, employer's liability, the
aviation industry, the transportation of property (ie, marine insurance), and reinsurance. P&C insurers sell
insurance policies through direct writing using in-house staff and marketing teams or through agency writing
using external agents and brokers.
P&C policies are generally short-term in nature. Since P&C claims arise from unpredictable accidents, the
cash outflows related to the claim settlements are more variable and uneven than claims faced by life and
health insurance companies. Claims may even occur after the policy has expired (eg, claims on policies
that covered asbestos liability). P&C insurers can diversify their risks by selling a range of products and
transferring some of their policies to reinsurers.
Earnings Characteristics
The P&C insurance industry is cyclical and highly competitive:
Vol 2-76
Exhibit 2 Cyclicality of property and casualty industry pricing
Hard insurance market
Low industry combined ratio

(ie, low expenses to income)
High margins attract new entrants
Increased competition Reduced competition

pushes down premiums increase premiums
Soft insurance market
High industry combined ratio

(ie, high expenses to income)
Low margins lead some insurers to exit
The ratios used to analyze the profitability of P&C insurers include the loss and loss adjustment expense
ratio, which compares the total loss expense and loss adjustment expense with net premiums earned, and
the underwriting expense ratio, which compares the underwriting expense with net premiums written.
The combined ratio after dividends is the sum of three ratios: loss and loss adjustment expense,
underwriting expense, and dividends to policyholders, as shown in Exhibit 3:
Exhibit 3 Combined ratio after dividends
Combined ratio
Combined ratio after Loss and loss adjustment Underwriting Dividends to

= + +
dividends (CRAD) expense ratio expense ratio policyholders ratio
Loss expense + Loss Underwriting Dividends to

adjustment expense expense policyholders
+ +
Net premiums Net premiums Net premiums
earned written earned
A combined ratio of less than 100% is considered efficient, while a combined ratio of greater than 100%
indicates an underwriting loss. The combined ratio after dividends is a more stringent measure of overall
efficiency as it includes the cash return to policyholders (or shareholders).
Net premiums written that are earned over a relevant accounting period are referred to as net
premiums earned.
Vol 2-77
Learning Module 4
Example 9 Analyzing profitability for a P&C insurer
The table below shows selected financial information for a P&C insurer.
Financial information 20X2
Net premiums written 6,460

Net premiums earned 6,311
Net investment income 575
Net investment gains 336
Insurance service fees 135
Total revenues 7,685
Loss expense and loss adjustment expense 4,002
Underwriting expense 2,337
Dividends to shareholders 188
What is the loss and loss adjustment expense ratio in 20X2?
What is the underwriting expense ratio in 20X2?
What is the combined ratio after dividends in 20X2?
Solutions
Loss and loss adjustment expense ratio = Loss expense + Loss adjustment expense / Net
premiums earned:
4,002
= 63.4%
6,311
Underwriting expense ratio = Underwriting expense / Net premiums written:
2,337
= 36.2%
6,460
Combined ratio = Loss and loss adjustment expense ratio + Underwriting expense ratio:
63.4% + 36.2% = 99.6%
Dividends to shareholders ratio = Dividends paid / Net premiums earned:
188
= 3.0%
6,311
Combined ratio after dividends:
99.6% + 3.0% = 102.6%
An analysis of a P&C insurer's profitability should also include a review of the schedule of activity in loss
reserve balances, as the increase in loss reserves is typically the largest component of total claims and
expenses in the income statement and can be difficult to estimate accurately.
Vol 2-78
Example 10 Analyzing loss reserve balances
The table below shows the reconciliation of beginning-of-year and end-of-year loss reserves for a P&C
insurer. The P&C insurer has also reported 6,911 of total claims and expenses in its income statement.
Reconciliation of loss reserves 20X2
Net reserves at beginning of year 9,590
Net provision for losses and loss expenses:

Claims occurring during the current year 4,007
Decrease in estimates for claims occurring in prior years (5)
Total 4,002
Net payment for claims:

Current year (1,027)
Prior years (2,563)
Total (3,590)
Foreign translation adjustment 55

Net reserves at end of year 10,057
Ceded reserves at end of year 1,613
Gross claims and claim adjustment expense reserves 11,670
at end of year
What does the proportion of claims that occurred and were paid in 20X2 to the provision for claims
occurring during that year indicate about the insurer's liability exposure?
What proportion of gross loss reserves has the insurer ceded to reinsurers?
What proportion of total claims and expenses in the income statement does total increases in loss
reserves represent?
Solutions
Claims that occurred and were paid in 20X2 as a proportion of the provision for claims occurring during
that year:
1,027
= 25.6%
4,007
This indicates that a significant proportion of the insurer's liability exposure is relatively short-term.
Proportion of gross loss reserves ceded to reinsurers:
1,613
= 13.8%
11,670
Total increases in loss reserves as a proportion of total claims and expenses in the income statement:
4,002
= 57.9%
6,911
Vol 2-79
Learning Module 4
An insurer can transfer or sell a portion of its risk to a reinsurer for a premium, expecting to recover its
losses from the reinsurer on the ceded portion of risk.
Investment Returns
Due to the unpredictability of claim payouts, P&C insurers invest insurance premiums in low-risk, liquid
assets so that claims can be settled promptly. The majority of a P&C insurer's investment portfolio consists
of fixed-maturity investments that yield steady returns, such that investment income is usually less volatile
than operating income. Investment performance can be evaluated by calculating the return on invested
assets (ie, investment income as a percentage of invested assets, including cash).
Liquidity
The unpredictability of claim payouts means that the assets of P&C insurers must be sufficiently liquid.
Analysis of an insurer's investment portfolio should assess the quality of the investment assets as well as
their market liquidity.
Both IFRS and US GAAP use a fair value hierarchy to assess the inputs for determining the fair value of
securities. The highest level of liquidity is Level 1, with values based on the quoted prices for securities
traded in active markets. Level 2 values are based on less liquid prices and markets, while Level 3 values
are based on models and unobservable inputs—due to a lack of active markets for the securities, which
indicates illiquidity.
Capitalization
There are no global risk-based capital standards for insurance companies, although minimum capital
requirements have been implemented for EU insurers (under the Solvency II regime) and US insurers
(under the National Association of Insurance Commissioners regime).
Analyzing Life and Health (L&H) Insurance Companies
L&H Insurance Companies

Like P&C insurers, L&H insurers offer risk management services, and their revenues come from insurance
premiums and from float. L&H insurers' policies have more longevity, and their payouts tend to be more
predictable than those for P&C insurers. Many L&H firms also offer investment services.
Operations: Products and Distribution

Life insurance products include term life, whole life, and universal life insurance policies, as well as
investment products such as annuities. Health-related insurance policies can be purchased to cover specific
medical expenses or to provide general coverage for injuries, illnesses, and treatments.
Term life insurance provides death benefits for a given period of time with no cash value. Whole life
insurance, which is typically based on level premiums, provides death benefits for the whole of the insured's
life as well as a cash value. Universal life insurance offers flexibility in term premiums, the amount of death
benefits, and savings and/or investment opportunities.
L&H insurers should be diversified across their product range and investment assets. Like P&C insurers,
they use direct writing and agency writing to sell their insurance products.
Vol 2-80
Earnings Characteristics
The main component of expenses for L&H insurers relates to payments of benefits and contract surrenders
(ie, policy cancellations before maturity) to policyholders. Earnings are therefore affected by estimates
of future policyholder benefits based on mortality rates. In addition, due to the long-term nature of life
insurance policies, L&H insurers capitalize the costs of acquiring new business and renewals and
subsequently amortize those costs on the basis of actual and expected future profits from the policies.
Analysts should be aware of the potential for earnings distortion when there is a mismatch in the way
certain assets and liabilities are valued (eg, when debt investments are marked to market but debt liabilities
are reported at amortized cost).
Common profitability ratios can be used to evaluate L&H insurers. Industry-specific ratios include total
benefits paid as a proportion of net premiums written plus deposits, as well as commissions and expenses
incurred as a proportion of net premiums written plus deposits.
Investment Returns
Investment returns are a major component of income for L&H insurers. Analysis of an L&H insurer's
investment portfolio should include the degree of diversification, investment performance, and interest rate
risk (eg, duration mismatch between assets and liabilities).
A common measure of investment performance is the return on invested assets, which is the ratio of
investment income to invested assets, including cash. This measure can be modified by adding realized
gains (or losses) and unrealized gains (or losses) to investment income for a more comprehensive analysis
of investment return.
Example 11 Analyzing investment returns for an L&H insurer
The tables below summarize the investment portfolio and investment income of an L&H insurer.
Investment portfolio 20X2 20X1
Loans and deposits 7,973 7,062

Debt securities 131,168 113,618
Equity securities 36,716 30,211
Derivative financial instruments 363 107
Total financial investments 176,220 150,998
Investment property 4,365 3,910
Total 180,585 154,908
Investment income
Interest income 5,599
Dividend income 695
Rental income 151
Investment income 6,445
Gains and losses 6,177
Total investment income 12,622
Vol 2-81
Learning Module 4
What is the return on average fixed-income assets, if fixed-income assets consist of debt securities and
loans and deposits? Assume that gains and losses related to debt securities comprise 91 of the 6,177 in
gains and losses.
Solutions
Investment income on fixed-income assets = Interest income + Gains on debt securities:
5,599 + 91 = 5,690
Average amount of debt securities and loans and deposits:
[(7,973 + 131,168) + (7,062 + 113,618)]

= 129,910.50
2
Return on average fixed-income assets:
5,690
= 4.4%
129,910.50
Liquidity
An L&H insurer requires liquidity to meet its obligations (ie, benefits and contract surrenders) to creditors
and policyholders. Liquidity sources include operating cash flow and liquidity provided by the insurer's
investment portfolio. Liquidity measures should compare an insurer's liquid assets (ie, cash and marketable
securities) with its short-term liabilities.
Capitalization
There are no global risk-based capital standards for L&H insurers, although they are required to meet
minimum capital requirements in various jurisdictions. Since L&H claims are more predictable than those
faced by P&C insurers, L&H insurers can have a lower equity cushion and lower capital requirements. Life
insurance products expose L&H insurers to significant interest rate risk, which is taken into account in the
calculation of risk-based capital requirements for these insurers.
Vol 2-82
Learning Module 5
Evaluating Quality of Financial Reports
LOS: Demonstrate the use of a conceptual framework for assessing the quality of a company's
financial reports.
LOS: Explain potential problems that affect the quality of financial reports.
LOS: Describe how to evaluate the quality of a company's financial reports.
LOS: Evaluate the quality of a company's financial reports.
LOS: Describe indicators of earnings quality.
LOS: Describe the concept of sustainable (persistent) earnings.
LOS: Explain mean reversion in earnings and how the accruals component of earnings affects
the speed of mean reversion.
LOS: Evaluate the earnings quality of a company.
LOS: Evaluate the cash flow quality of a company.
LOS: Describe indicators of balance sheet quality.
LOS: Evaluate the balance sheet quality of a company.
LOS: Describe indicators of cash flow quality.
LOS: Describe sources of information about risk.
Introduction
Assessing quality in financial reporting is a critical skill that is essential to making sound investment
decisions. An understanding of whether financial reports and, separately, their reported earnings are of high
or low quality can lead to more confidence in a recommendation or steps to obtain more information before
reaching a decision.
Vol 2-83
Learning Module 5
Conceptual Framework
LOS: Demonstrate the use of a conceptual framework for assessing the quality of a company's
financial reports.
Conceptual Framework for Assessing the Quality of Financial Reports

Assessing the quality of a company's financial statements relies on two related attributes: financial
reporting quality and earnings quality.
Financial reporting quality refers to the usefulness of information contained in the financial reports, including
disclosures in the notes. High-quality reporting provides information that is useful in investment decision making
as it is relevant, represents the company's performance and position, and adheres to accounting standards.
Exhibit 1 Quality spectrum of financial reports
Decision-useful, sustainable, and adequate returns

Decision-useful, low earnings quality Compliant
Biased choices with standards
Earnings management
Noncompliant with standards
Fictitious or omitted transactions
Standards: Generally accepted accounting principles (eg, IFRS, US GAAP)
When evaluating the quality of financial statements, an analyst must assess whether the statements are
GAAP-compliant and decision-useful, and whether the company's earnings provide an adequate level of
return and are sustainable.
Earnings quality (or results quality) pertains to the earnings and cash generated by the company's core
economic activities and its resulting financial condition. High-quality earnings (1) come from activities that
the company will be able to sustain in the future, and (2) provide an adequate return on the company's
investment. Note that the term earnings quality encompasses quality of earnings, cash flows, and balance
sheet items.
These two attributes are interrelated because earnings quality cannot be evaluated until there is some
assurance regarding the quality of financial reporting. If financial reporting quality is low, the information
provided is not useful for evaluating company performance or making investment decisions.
Vol 2-84
Exhibit 2 Reporting quality vs. earnings quality
Reporting and Overall financial

Characteristics
earnings quality statement quality
y Compliant with US GAAP or IFRS High
High reporting y Conservative accounting policies

high earnings y Sustainable earnings
y Company value increases
y Compliant with US GAAP or IFRS

High reporting
y More aggressive accounting policies
low earnings
y Less sustainable earnings
y Possibly complaint with US GAAP or IFRS

y Very aggressive accounting
Low reporting
y Possible fraud
low earnings
y Unsustainable earnings
y Company value decreases Low
Potential Problems
The basic choices that can create issues regarding the quality of financial reports relate to (1) reported
amounts and timing of recognition and (2) classification.
Reported Amounts and Timing of Recognition

A company's choices regarding reported amounts and timing of recognition may focus on a single element
of its financial statements (ie, assets, liabilities, owners' equity, revenues and gains, or expenses and
losses), and those choices may or may not be compliant with standards. They might also affect other,
interrelated items and financial statements.
Aggressive, premature, and fictitious revenue recognition can result in overstated income and,
consequently, overstated equity and assets. Conservative (eg, deferred) revenue recognition can result in
understated net income, equity, or assets that will be overstated in some future period.
Omission and delayed recognition of expenses can result in understated expenses and liabilities, as well as
overstated income, equity, and assets. For example, the understatement:
y of bad debt expense results in overstated accounts receivable.

y of depreciation or amortization results in overstated long-lived assets.
Vol 2-85
Learning Module 5
y of interest, taxes, or other expenses results in understated related liabilities (ie, accrued interest
payable, taxes payable, or other payables).
y of contingent liabilities results when equity is overstated due to either understated expenses and
overstated income or overstated other comprehensive income.
When financial assets and liabilities must be reported at fair value, overstating the assets and understating
the liabilities will lead to overstated equity since unrealized gains (losses) will be overstated (understated).
Cash flow from operations may be increased by accelerating payments from customers and by deferring
payments on payables, purchases of inventory, and other expenditures (eg, maintenance, research).
Classification
Choices of classification typically relate to how an item is classified within a particular financial statement.
Consider the following examples:
y A company seeking to understate its accounts receivable (AR) in order to mask issues of liquidity or
revenue collection could reduce the AR balance by:
○ selling AR externally,
○ transferring AR to a controlled entity,
○ converting AR to notes receivable, or
○ reclassifying AR within the balance sheet and reporting the amounts as long-term receivables.
Although the amounts would remain on the balance sheet as receivables of some sort, the AR balance
itself would be lower, resulting in a deceptively favorable change in measures such as days sales
outstanding and receivables turnover.
y A company seeking to lower the ending inventory on its balance sheet for the current year could do so
by reclassifying certain inventory costs as other assets. It could justify the classification on the grounds
that those units of inventory are held in preparation for future product launches and are not expected
to be sold within a year or one operating cycle. While this reasoning appears logical, the change in
classification poses analytical problems as it results in:
○ an increase in the inventory turnover ratio,
○ a reduction in the number of days of inventory on hand, and
○ a decrease in the current ratio.
Further, a time series comparison of these ratios will produce an inconsistent history if the amount of
inventory that would have been classified as "other assets" in prior periods is not disclosed.
y A company seeking to inflate reported cash flow from operations could do so by classifying activities
such as sales of long-term assets as operating activities (instead of investing activities). To achieve
the same outcome, the company might also capitalize its operating expenditures, rather than expense
them; the related outflow would then be classified as an investing, not an operating, activity.
y A company that wants changes in the value of its financial investments to flow through other
comprehensive income, rather than the income statement, can classify those investments as available-
for-sale instead of held-for-trading.
Vol 2-86
Exhibit 3 Misclassification and warning signs
Potential issues Possible actions/choices Warning signs
y Overstatement or y Contingent sales with right y Growth in revenue higher than that
non-sustainability of return, channel stuffing, of industry or peers
of operating income bill-and-hold sales
y Increases in discounts or returns
and/or net income
y Reporting fictitious
y Higher growth rate in receivables
y Overstated or (fraudulent) revenue
than revenue
accelerated
y Capitalizing expenditures
revenue recognition y Large proportion of revenue
as assets
in final quarter of year for a
y Understated expenses
y Classifying nonoperating non-seasonal business
y Misclassification income or gains as part of
y Cash flow from operations is much
of revenue, gains, operations
lower than operating income
expenses, or losses
y Classifying ordinary
y Inconsistency over time in operating
expenses as nonrecurring
revenues and operating expenses
or nonoperating
y Increases in operating margin
y Reporting gains
through net income and y Aggressive accounting assumptions
losses through other (eg, long depreciable lives)
comprehensive income y Losses in nonoperating income or
other comprehensive income
y Compensation largely tied to
financial results
y Misstatement of balance y Manipulating the choice of y Models and model inputs that bias
sheet items (may affect models and model inputs fair value measures
income statement) to measure fair value
y Inconsistency in model inputs when
y Over- or understatement y Changing classification measuring fair value of assets
of assets from current to noncurrent compared with that of liabilities
y Over- or understatement y Over- or understating y Current assets (eg, accounts
of liabilities reserves and allowances receivable) included in
noncurrent assets
y Misclassification of y Understating
assets and/or liabilities identifiable assets and y Allowances and reserves that
overstating goodwill fluctuate over time or are not
comparable with peers
y High goodwill value relative to
total assets
y Use of special purpose vehicles
y Large changes in deferred tax
assets and liabilities
y Significant off-balance-sheet
liabilities
Vol 2-87
Learning Module 5
Potential issues Possible actions/choices Warning signs
y Overstatement of cash y Manipulating activities y Increase in accounts payable,

flow from operations to distort cash flow decrease in accounts receivable
from operations and inventory
y Misclassifying cash flows y Capitalized expenditures in
to positively affect cash investing activities
flow from operations
y Sale-and-leaseback transactions
y Increases in bank overdrafts
© CFA Institute
M&A Issues and Divergence from Economic Reality
Mergers and acquisitions (M&A) can introduce complexities and provide opportunities to inappropriately
manage financial results.
When businesses combine, financial results are reported on a consolidated basis; this can be used to
conceal many issues, such as those related to cash flow. If the acquisition is paid for in cash, the outflow will
be reported under investing cash flow, while reported consolidated cash flow from operations will include
the acquired company's cash flow. Acquisitions may create an incentive for management to use aggressive
accounting choices (eg, the acquirer paying with stock to boost its share price) or even misreport. Acquiring
companies may try to manipulate earnings upward after an acquisition if they want to positively influence
investors' opinion of the acquisition.
An acquisition may also be made in order to hide prior accounting misstatements. Acquisitions provide
opportunities to make accounting choices that affect both the initial consolidated balance sheet and
consolidated income statements in the future. When a business combination occurs, the acquirer must
measure and recognize all identifiable assets acquired and liabilities assumed at their fair values as of the
acquisition date. The excess of the purchase price over the recognized value of the identifiable net assets
acquired is reported as goodwill. Since goodwill is not amortized, management may be tempted to overstate
goodwill by understating the value of net assets acquired, which allows for understating depreciation/
amortization expenses going forward and inflating reported net income.
Financial Reporting That Diverges from Economic Reality Despite

Compliance with Accounting Rules
An analyst may have to decide whether certain items reported in accordance with accounting standards
are recurring or true one-off items, and then adjust accordingly to "normalize" earnings. Such items include
revisions to ongoing estimates, increases in allowances and reserves, and accruals for losses, which may
suggest that prior periods' earnings were overstated.
Accounting standards can also lead to some economic assets or liabilities not being fully reflected in
financial reports. An example is research and development (R&D) expenses, which are expensed in the
current period although they are used over a longer period of time, creating a discrepancy between reported
numbers and economic reality.
Vol 2-88
In addition, analysts must consider whether certain items presented in other comprehensive income should be
included in their analysis as net income. Examples of such items include unrealized holding gains and losses
on certain investments in equity securities, unrealized holding gains (and subsequent losses) on long-lived
assets accounted for using the revaluation model (IFRS only), or foreign currency translation adjustments.
General Steps of Evaluation
LOS: Describe how to evaluate the quality of a company's financial reports.
General Steps to Evaluate the Quality of Financial Reports

y Develop an understanding of the company and its industry. Understanding the economic activities and
accounting principles of both a company and its industry provides a basis for evaluating whether the
company's financial reporting practices reflect economic reality or distort results.
y Learn about management.
○ Obtain an understanding of management's incentives and the actions those incentives would
likely motivate.
○ Review disclosures regarding management's transactional activities and any outside
business activities.
y Identify accounting areas that rely on management's discretion or judgment or involve an unusual
accounting rule.
y Make comparisons.
○ Compare the current year's financial statements with those of prior periods. Look for major
differences in certain line items or changes in accounting methods or level of disclosure.
○ Compare the company's accounting policies with those of its competitors. If significant differences
are found, assess whether there are legitimate reasons for those differences.
○ Use ratio analysis to compare the company's performance with that of its competitors and industry.
y Check for warning signs of possible issues with the quality of the financial reports (eg, declining
turnover in receivables or inventory, net income greater than cash from operations).
y For multinational firms, consider whether assets, revenues, or expenses have been shifted to make
it appear that the company is positively exposed to a geographic region or product segment that the
investment community considers a desirable growth area. A shift may be occurring if the segment
shows strong performance while the consolidated results remain static or worsen.
y Use appropriate quantitative tools to assess the likelihood of misreporting.
Vol 2-89
Learning Module 5
Quantitative Tools to Assess the Likelihood of Misreporting
LOS: Describe how to evauate the quality of a company's financial reports.
LOS: Evaluate the quality of a company's financial reports.
Beneish Model
Based on several studies aimed at identifying quantitative indicators of earnings manipulation, Messod D.
Beneish came up with an expression for computing the probability of manipulation (M-score).
Exhibit 4 Beneish model: calculating the M-score
M-score = −4.84 + (0.920 × DSR) + (0.528 × GMI) + (0.404 × AQI)

+ (0.892 × SGI) + (0.115 × DEPI) − (0.172 × SGAI)
+ (4.679 × Accruals) − (0.327 × LEVI)
Higher M-scores → higher likelihood of earnings manipulation
Variable Description
ARt / Salest
DSR: days sales receivable index
ARt − 1 / Salest − 1
Gross margint − 1
GMI: gross margin index
Gross margint
1 − (PPEt + CA t) / TAt
AQI: asset quality index
1 − (PPEt −1 + CAt − 1) / TAt − 1
Salest
SGI: sales growth index
Salest − 1
Depreciation ratet − 1
DEPI: depreciation index
Depreciation ratet
SG&At / Salest
SGAI: SG&A index
SG&At − 1 / Salest − 1
Accruals Net income − OCF
Debtt / TAt
LEVI: leverage index
Debtt − 1 / TAt − 1
AR = Accounts receivable CA = Current assets

TA = Total assets SG&A = Sales, general, and administrative expenses
Vol 2-90
The M-score in the Beneish model is a normally distributed random variable with a mean of 0 and a
standard deviation of 1.0; thus, the probability of earnings manipulation is assumed to be normally
distributed. The greater the M-score (ie, the less negative the number), the greater the probability of
earnings manipulation.
Example 1 Application of the Beneish Model
The following table presents the variables and the Beneish model M-score for ABC Company:
Value of variable Coefficient from Beneish model Calculations
DSR 1.2 0.920 1.1040

GMI 1.2 0.528 0.6336
AQI 0.7 0.404 0.2828
SGI 1.2 0.892 1.0704
DEPI 1.1 0.115 0.1265
SGAI 0.7 −0.172 −0.1204
Accruals 0.1 4.670 0.4670
LEVI 0.5 −0.327 −0.1635
Intercept −4.2500
M-score −0.8496
Probability of 19.77%
manipulation
y Using an M-score of −1.78 as a cutoff, would the results presented lead an analyst to conclude that
ABC is a likely manipulator?
y What do the values of DSR, GMI, SGI, and DEPI (all greater than 1) indicate regarding the company?
Solutions
y Based on the results presented, an analyst would likely conclude that ABC is an earnings
manipulator. The M-score (−0.8496) is higher than the cutoff (−1.78), indicating a higher-than-
acceptable probability of manipulation.
y Indications are as follows:
○ A DSR greater than 1 indicates that the ratio of receivables to sales has increased. This may
suggest that ABC has employed inappropriate revenue recognition practices (eg, the company
may have shipped goods prematurely to recognize revenue that actually belongs to later
periods). It is also possible that ABC's customers are having trouble paying the company.
○ A GMI greater than 1 indicates that gross margins have fallen this year. The deteriorating
financial performance may induce management to manipulate earnings.
○ A SGI greater than 1 indicates that sales have increased this year. It is possible that the
company has employed aggressive revenue recognition practices to manage perceptions of
continuing growth and/or to obtain capital required to support growth.
○ A DEPI greater than 1 indicates that the depreciation rate is lower this year. It is possible
that the company is playing around with depreciation methods/estimates to manipulate
reported earnings.
Vol 2-91
Learning Module 5
Other Quantitative Models

Other variables that are useful for detecting accounting manipulation include accruals, deferred taxes,
auditor changes, market-to-book value, publicly listed and traded equity, growth rate differences between
financial and nonfinancial variables, and aspects of corporate governance and incentive compensation.
Limitations of Quantitative Models

Accounting is only a partial representation of economic reality. Underlying cause-and-effect relationships
can be determined only by a deeper analysis of actions.
Managers have learned to test the detectability of earnings manipulation tactics by using models (such as
the Beneish model) to anticipate analysts' perceptions. As a result, the predictive power of these models
has declined.
Earnings Quality Indicators
LOS: Describe indicators of earnings quality.
Earnings quality refers to earnings, cash flow, and balance sheet quality as a whole. High-quality earnings
are sustainable and represent an adequate rate of return (in excess of the firm's cost of capital). The
conclusion that a particular company has high-quality earnings assumes that reporting quality is also high.
Indicators of Earnings Quality
Recurring Earnings
In general, reported earnings that contain a high proportion of nonrecurring items (eg, discontinued
operations, one-off asset sales, one-off litigation settlements, one-off tax settlements) are less likely to be
sustainable and are therefore considered low quality.
Vol 2-92
Example 2 Nonrecurring Items (Enron Corp.)
The following table provides selected information from the consolidated income statement of Enron and
its subsidiaries for the year ended Dec 31 2000.
(In millions) 2000 1999 1998
Total revenues $100,789 $40,112 $31,260

Total costs and expenses 98,836 39,310 29,882
Operating income $1,953 $802 $1,378
Other income and deductions

Equity in earnings of unconsolidated equity affiliates $87 $309 $97
Gains on sales of non-merchant assets 146 541 56
Gain on the issuance of stock by TNPC, Inc. 121 0 0
Interest income 212 162 88
Other income, net −37 181 −37
Income before interest, minority interests, and income taxes $2,482 $1,995 $1,582
y Enron's "operating income" varied drastically from year to year, falling by almost 42% in 1999 (from
$1,378m to $802m) before rising by more than 100% in 2000 (to $1,953m).
y On the other hand, "income before interest, minority interests, and income taxes" shows a smooth
upward trend, rising by 26% (from $1,582m to $1,995m) in 1999 and by 24% (to $2,482m) in 2000.
y "Gains on sales of non-merchant assets" and "gains on issuance of stock by TNPC, Inc." appear to
be nonrecurring items:
○ Even though gains on sales of non-merchant assets are realized in each of the three years,
these gains have no relation to Enron's core energy distribution operations.
○ Gains on the stock sales were realized only in 2000.
y "Equity in earnings of unconsolidated equity affiliates" and "other income" are both nonoperating
items and are highly variable.
y The smooth upward trend in Enron's income is a direct result of the nonrecurring and nonoperating
items. Further, these items also represent a significant portion of the company's "income before
interest, minority interests, and income taxes." For example, in 1999, the nonrecurring and
nonoperating items accounted for more than 50% of the total [= ($309 + $541 + $181) / $1,995].
It is important to include nonrecurring items in historical comparisons and the development of input
estimates for valuation. However, analysts should always keep an eye out for classification shifting
when estimating recurring or core earnings. Evidence suggests that classification shifting does exist
as companies:
y reclassify normal expenses as special items and/or

y shift operating expenses to discontinued operations in order to inflate recurring earnings.
Since evidence of classification shifting typically emerges only after the fact, analysts should scrutinize
special items that decrease income—especially if classifying those items as nonoperating would help the
company report relatively high operating earnings over the period.
Vol 2-93
Learning Module 5
Companies understand that investors focus on recurring or core earnings. Therefore, in addition to reporting
net income (on the face of the income statement), many companies voluntarily disclose pro forma income
(ie, adjusted income or non-GAAP earnings) that excludes nonrecurring items. A reconciliation of pro forma
income to reported income is also provided.
Analysts should be aware that some companies may be motivated to classify an item as nonrecurring if that
classification would improve a performance metric that is important to investors. For example, Groupon,
an online discount provider, excluded online marketing costs from its reported pro forma income on the
grounds that they were nonrecurring customer acquisition costs and the company was planning to reduce
the customer acquisition part of its marketing expenses over time. However, the SEC determined that the
exclusion was misleading and subsequently required Groupon to restate its pro forma income. So, although
voluntarily disclosed adjustments to reported income can be informative, an analyst should review the
information to ensure that excluded items are truly nonrecurring.
Earnings Persistence and Related Measures of Accruals
LOS: Describe the concept of sustainable (persistent) earnings.
Earnings persistence refers to the sustainability of earnings, excluding items that are nonrecurring and the
persistence of growth in those earnings. The higher the persistence of a company's earnings, the higher its
intrinsic value. Persistence can be measured by the coefficient β in the following model:
Earningst + 1 = α + β1Earningst + ε
Earnings have a cash component and an accruals component. The accruals component arises from
accounting requirements to recognize revenues/expenses in the period that they are earned/incurred, not
at the time of cash movement. For example, a sale of goods in one period results in accounting income in
the period the sale is made; however, the cash could be collected during the next period, and the difference
between reported net income and cash collected represents an accrual.
Earningst + 1 = α + β1Cash flowt + β2Accrualst + ε
Historical evidence indicates that the cash component of earnings is more persistent than the accruals
component, so β1 tends to be greater than β2. The larger the accruals component of earnings, the lower the
level of persistence and, therefore, the lower the quality of earnings. Accruals can be roughly estimated as
net income minus operating cash flow.
Exhibit 5 Cash and accruals components of earnings
Cash
component
Nondiscretionary
Earnings
(normal)
Accruals
component
Discretionary
(abnormal)
Vol 2-94
An important distinction can be made between discretionary and nondiscretionary accruals. Discretionary
accruals arise from transactions or accounting choices that may be made at the discretion of management
in order to manage earnings. Nondiscretionary accruals arise from normal transactions.
There are two ways to identify abnormal discretionary accruals:
y Model the company's normal accruals and then identify outliers. The company's normal accruals are
a function of economic factors (eg, growth in credit sales, which would increase accounts receivable,
and growth in the amount of depreciable assets, which would increase depreciation expense). Total
accruals are regressed against factors that are likely to give rise to normal accruals, and the residual of
this regression is used as a measure of abnormal accruals.
y Compare the magnitude of total accruals across companies. In order to make the comparison relevant,
accruals are typically scaled (by average assets or average net operating income). A high amount of
accruals indicates the possibility of manipulated, low-quality earnings.
A relatively strong signal that earnings are being manipulated is when a company reports positive net
income, but with negative operating cash flows. Allou Health & Beauty Care, Inc. provides a good example
of such a warning sign. The company was a manufacturer and distributor of hair and skin care products.
Its financial statements for the years 2000–2002 showed positive revenue growth, fairly stable gross and
operating margins, and positive net income each year, all suggesting that the company was reasonably
stable. However, Allou reported negative cash flow from operating activities for each of the three years,
which raised questions regarding its sustainability as a going concern. The explanation offered was that the
company's accounts receivable and inventory had increased over the period. Subsequently, it was found
that Allou had fraudulently inflated the amount of sales and inventory for those years.
Although significant accruals can suggest earnings manipulation, not all fraudulent companies have
sizeable accruals. WorldCom, Inc., which was found to have issued fraudulent reports, had shown cash flow
from operating activities in excess of net income for each of the three years before the discovery was made.
The company accomplished this by improperly capitalizing certain operating costs instead of expensing
them, thereby classifying related cash outflows as investing outflows (instead of operating cash outflows).
An analyst who focused only on net income and cash flow from operations might have concluded that
WorldCom's earnings were of high quality, but one who also considered cash flow from investing activities
would have seen the bigger (correct) picture.
Mean Reversion in Earnings
LOS: Explain mean reversion in earnings and how the accruals component of earnings affects
the speed of mean reversion.
Research has shown that earnings levels are mean reverting (ie, they tend to revert to normal levels
over time). A company performing poorly will shut down, take action to minimize losses, or upgrade its
management or strategy in order to improve earnings going forward. A company earning abnormal profits
will eventually face competition, leading to reduced profit margins over time.
Vol 2-95
Learning Module 5
Exhibit 6 Mean reversion in earnings
ROE
Firm A: above-average ROE High returns attract new competitors
Competition reduces prices
Returns decrease
Industry average ROE Returns increase
Firms with low returns typically:

• Close or reorganize weaker units
• Replace management
Firm B: below-average ROE • Improve strategy
Time
These findings provide a valuable lesson for analysts. Extremely high/low earnings should not simply be
extrapolated into the future when constructing forecasts. Instead, analysts should focus on projecting
normalized earnings over the relevant valuation time frame. Besides making these earnings projections,
analysts must also develop a realistic cash flow model and realistic estimates of accruals. The cash
component of earnings tends to be more persistent than the accruals component. Therefore, if a company's
earnings have a higher-than-normal accruals component, they can be expected to revert toward the mean
more quickly.
Beating Benchmarks
Earnings that meet or exceed analysts' consensus forecasts typically result in share price increases.
Studies have shown that a statistically significant proportion of earnings announcements slightly exceeds
forecasts, compared with announcements that fall short of those forecasts; this has been interpreted by
some as evidence of earnings management. While this interpretation is open to debate, analysts should be
wary of companies whose earnings reports exactly meet or narrowly beat forecasts on a consistent basis,
as they may be managing the reported earnings.
External Indicators of Poor-Quality Earnings

Two external indicators of poor-quality earnings are enforcement actions by regulatory authorities and
restatements of previously issued financial statements. As analysts strive to recognize companies with poor
earnings quality before it becomes known to the public, they should stay alert to external indicators and be
prepared to reassess their investment decisions.
Vol 2-96
Bankruptcy Prediction Models
LOS: Evaluate the earnings quality of a company.
In addition to addressing the quality of a company's earnings, bankruptcy prediction models include aspects
of the company's balance sheet and cash flow.
Altman Model
This model incorporates several financial ratios into a single model to predict the probability of bankruptcy,
based on liquidity, profitability, activity, and leverage.
Exhibit 7 Altman model: Calculating the Z-score
Lower Z-scores → Greater probability of bankruptcy
Z-score is the sum of: Z-score measures:
1.2 × (Net working capital / Total assets) Short-term liquidity risk
+ 1.4 × (Retained earnings / Total assets) Accumulated profitability and relative age
+ 3.3 × (EBIT / Total assets) Profitability; variant of ROA
+ 0.6 × (MV or equity / BV of liabilities) Leverage
+ 1.0 × (Sales / Total assets) Activity: ability to generate sales
= Z-score Probability of bankruptcy
MV = Market Value, BV = Book value
When it comes to interpreting the model, a higher Z-score is better.
Developments in Bankruptcy Prediction Models

Bankruptcy prediction models, such as the Altman model, have limitations. For example, the Altman
model uses only one set of financial measures and thus is static. Subsequent models have incorporated
data collected over an extended period to create a time series. Subsequent models have also made
use of market-based prediction tools that view equity in a company as a call option on the company's
assets; such models infer the probability of default from the value of the company's equity, its debt, equity
returns, and equity volatility. Newer models have used both accounting-based and market-based data as
predictive variables.
Vol 2-97
Learning Module 5
Cash Flow Quality
LOS: Describe indicators of cash flow quality.
Indicators of Cash Flow Quality

Discussions of cash flow quality focus on operating cash flow (OCF) since it is the most important cash
flow component for assessing a company's performance and valuing its securities. Cash flow can be of low
quality if the reported information correctly reflects poor economic performance (poor results quality) or if
this information misrepresents economic reality (poor reporting quality). For cash flows to be regarded as
high quality, there must be high quality of both results and reporting.
Startups and early-stage companies can be expected to have negative operating and investing cash
flows, which may be funded by financing cash flows (eg, issuing debt or equity). For more established
companies, high-quality OCFs are positive, derived from sustainable sources, adequately cover CAPEX
and distributions to stakeholders, and have relatively low volatility.
OCF is generally viewed as more difficult to manipulate than operating income and net income. However,
the importance of OCF to investors creates a strong incentive for managers to manipulate the amounts
reported. Other issues related to cash flow reporting quality include management boosting OCF by selling
receivables to a third party, delaying payment of payables, and misclassifying cash flows.
Evaluating Cash Flow Quality

The statement of cash flows is a valuable tool to assess earnings quality. When evaluating cash flow quality,
analysts should consider the following potential issues:
Cash flow and earnings discrepancies may indicate misalignment between reported results and
economic reality. Ongoing differences in these values can be a sign that something is off in the
financial reporting.
Classification shifting refers to a change in how a certain cash flow is categorized, whether as operating,
investing, or financing cash flows. Companies have some flexibility in classification, but frequent changes
may indicate that the company is trying to conceal something.
Consistency in reporting is essential when assessing cash flow and earnings quality. Sudden fluctuations
in results, large one-time expenses or noncash items, or material changes in accounting choices may
signify that positively perceived results are not real or sustainable.
Comparisons of period-to-period reports issued by a company can be useful for assessing financial
reporting quality. If a company restates prior years' financial statements due to an error or a change in
accounting policy, omits some information that was previously voluntarily disclosed, or adds an item that
was not previously disclosed, an analyst should seek to understand the reasons for the changes.
Vol 2-98
Balance Sheet Quality
High-quality balance sheet results are characterized by an optimal amount of leverage, adequate liquidity,
and optimal asset allocation. Since there are no absolute values for the various financial ratios that indicate
adequate financial strength, the analyst should consider the environment of the firm. High financial reporting
quality is indicated by completeness, unbiased measurement, and clear presentation.
Completeness refers to a complete representation of the company's assets and liabilities on the balance
sheet. Significant amounts of off-balance-sheet obligations, nontransparent variations in accounting for
business interests, or a failure to properly report unconsolidated subsidiaries may indicate the company is
attempting to manipulate financial results.
Unbiased measurement is particularly important when the valuation of certain assets and liabilities is
subjective. For example, bias could become a factor when assessing asset impairment charges, valuation
allowance for deferred tax assets, investments that trade in nonactive markets, or pension liabilities.
Example 3 Goodwill
The tables below show an excerpt from Sealed Air Corporation's income statement and balance sheet
for 2012.
Year ended Dec 31 ($ millions) 2012 2011 2010
Net sales $7,648.1 $5,550.9 $4,490.1

Cost of sales 5,103.8 3,950.6 3,237.3
Gross profit 2,544.3 1,600.3 1,252.0
Marketing, administrative, and development expenses 1,785.2 1,014.4 699.0
Amortization expense of intangible assets acquired 134 39.5 11.2
Impairment of goodwill and other intangible assets 1,892.3 — —
Costs related to the acquisition and integration of a
7.4 64.8 —
target business
Restructuring and other charges 142.5 52.2 7.6
Operating (loss) profit −1,417.1 429.4 535
Interest expense −384.7 −216.6 −161.6
Vol 2-99
Learning Module 5
Year ended Dec 31 ($ millions) 2012 2011
Assets
Current assets
Cash and cash equivalents $679.6 $703.6
Receivables, net of allowance for doubtful
1,326.0 1,314.2
accounts
Inventories 736.4 777.5
Deferred tax assets 393 156.2
Assets held for sale — 279
Prepaid expenses and other current assets 87.4 119.7
Total current assets $3,222.4 $3,350.2
Property and equipment, net $1,212.8 $1,269.2
Goodwill 3,191.4 4,209.6
Intangible assets, net 1,139.7 2,035.7
Noncurrent deferred tax assets 255.8 112.3
Other assets, net 415.1 455
Total assets $9,437.2 $11,432.0
Excerpt from Sealed Air Corporation and Subsidiaries Consolidated Balance Sheets
The company has 192,062,185 shares outstanding. These shares were valued at $18 each in Dec 2011
and at $14 each in Aug 2012.
Note the following from the information presented:
y The company's market capitalization was approximately $3,457 million (= 192,062,185 × $18) in
Dec 2011 and around $2,689 million (= 192,062,185 × $14) in Aug 2012.
y The amount of goodwill reported by the company on its balance sheet as of Dec 2011 was $4,209.6
million. This amount comfortably exceeded the company's market cap on that date ($3,457 million).
Further, goodwill and other intangible assets represented about 55% of the company's total assets
[= (4,209.6 + 2,035.7) / 11,432.0].
y Because the company's market capitalization is lower than the reported goodwill, the value
attributed to all its other assets is less than zero. This suggests that goodwill is carried at an inflated
value and that a future write-down is likely.
y As can be seen on the company's income statement for 2012, an impairment charge worth
$1,892.3 million was subsequently recognized against goodwill and other intangible assets.
Clear presentation refers to the company's willingness to represent as closely as possible the economic
reality of the business. Although accounting standards specify many aspects of what appears on the
balance sheet, companies have discretion when determining which line items should be shown separately
and which ones should be aggregated into a single total. For items shown as a single total, companies
should make the required details available in the notes to the financial statements.
Vol 2-100
Sources of Information About Risk
A company's financial statements can provide useful indicators of financial, operating, or other risk.
For example:
y High leverage ratios or low coverage ratios can signal financial risk.
y Analytical models that incorporate various financial data can signal bankruptcy risk, and other models
can predict reporting risks.
y Highly variable operating cash flows or negative trends in profit margins can signal operating risk.
Limited Usefulness of Auditor's Opinion as a Source of Information

About Risk
An adverse or going-concern audit opinion on financial statements, or a report indicating weakness
in the company's internal controls, would be a warning sign. However, audit opinions are based on
historical information, which is generally not timely enough for the opinions to be a useful source of
information about risk.
On the other hand, a change or multiple changes of auditor can be a signal of possible reporting problems.
Similarly, the use of an auditor who does not appear to be equipped to adequately deal with the complexity
of the company can indicate risk. Analysts should be concerned if the auditor and company management
are particularly close, or if the company represents a significant portion of the auditor's revenue.
Risk-Related Disclosures in the Notes
Both IFRS and US GAAP require specific disclosures about risks related to contingent obligations, pension
and post-employment benefits, and financial instruments.
y Disclosures about contingent obligations include a description of the obligation, estimated amounts,
timing of required payments, and related uncertainties.
y Disclosures about pensions and post-employment benefits include information relevant to (1) actuarial
risks that could result in actual benefit payouts differing from the reported (or projected) obligations or
(2) investment risks that could result in actual assets differing from reported amounts, which are based
on expected returns.
y Disclosures about financial instruments include information about credit risk, liquidity risk, and market
risks, and how the company manages them.
Vol 2-101
Learning Module 5
Management Commentary, Other Required Disclosures, and the

Financial Press
IFRS require management commentary to include a discussion of principal strategic, commercial,

operational, and financial risks that may significantly affect the company. Similarly, public US companies
are required to present quantitative and qualitative information about the company's exposure to market
risks, enabling analysts to understand the impact of fluctuations in interest rates and in foreign exchange
and commodity prices. Although both IFRS and US GAAP encourage a presentation of only principal risks,
companies often include a significant amount of generic commentary, which may obscure other important
risks faced by a particular company.
Other Required Disclosures

Other required disclosures and announcements that are specific to an event (eg, issuance of capital,
non-timely filing of financial reports, management changes, mergers and acquisitions) can also provide
important information relevant to assessing risk.
In the United States, public companies must file a Form NT (notification of inability to timely file) if there is
a delay in filing financial reports. Delays in filing are often the result of accounting difficulties, which may be
due to internal disagreements on an accounting principle or estimate, a lack of adequate financial staff, or
a discovery of accounting fraud that requires further examination. In general, an NT filing is highly likely to
signal problems with financial reporting quality.
Other events should also be evaluated. For example, the sudden resignation of a company's most senior
financial officer or external auditor would signal potential problems with financial reporting quality. A legal
dispute related to one of the company's important assets or products could negatively affect the company's
future earnings. Mergers and acquisitions could also indicate changes in the company's risk profile.
Financial Press as a Source of Information About Risk

The financial press can be a useful source of information about risk. For example, a Wall Street Journal
financial reporter, Jonathan Weil, was one of the first people to identify problems with the accounting
at Enron. As the distribution of electronic media expands via the Internet, it is important to consider the
credibility of the source of any piece of information.
Vol 2-102
Learning Module 6
Integration of Financial Statement
Analysis Techniques
LOS: Demonstrate the use of a framework for the analysis of financial statements, given a
particular problem, question, or purpose (eg, valuing equity based on comparables, critiquing
a credit rating, obtaining a comprehensive picture of financial leverage, evaluating the
perspectives given in management's discussion of financial results).
LOS: Identify financial reporting choices and biases that affect the quality and comparability of
companies' financial statements and explain how such biases may affect financial decisions.
LOS: Evaluate the quality of a company's financial data and recommend appropriate
adjustments to improve quality and comparability with similar companies, including adjustments
for differences in accounting standards, methods, and assumptions.
LOS: Evaluate how a given change in accounting standards, methods, or assumptions affects
LOS: Analyze and interpret how balance sheet modifications, earnings normalization, and cash
flow statement related modifications affect a company's financial statements, financial ratios, and
overall financial condition.
Integration of Financial Statement Analysis Techniques
Financial analysis is primarily performed to facilitate an economic decision (eg, whether to lend to a company
or invest in a company's stock). A basic framework for conducting financial analysis is presented in Exhibit 1.
Exhibit 1 Financial statement analysis framework
Phase Action Result
y Articulate purpose of analysis y Written objective of analysis

Articulate purpose
y Determine the audience y Nature of reporting
y Obtain financial data y Organized financial statements

Collect data
y Visit company y Insight into goals and operations
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Learning Module 6
Phase Action Result
y Adjusted financial statements

y Adjust numbers
Process data y Common-sized statements
y Calculate data
y Financial ratios and forecasts
Analyze/interpret data y Understand the processed data y Analyst's report
Develop recommendation y Plot course of action y Recommendation report
Follow up y Repeat analysis as data changes y Reissue analyses and reports
This learning module demonstrates an application of the framework, using financial reports from Alpha Ltd.
Exhibit 2 Alpha's financial statements
Balance Sheet
20X4 20X3 20X2 20X1
Cash and cash equivalents 4,520 3,750 3,350 3,500

Marketable securities 2,200 4,554 8,250 7,120
Accounts receivable 11,950 10,800 9,565 7,825
Inventories 6,384 5,675 5,980 5,125
Other current assets 1,560 1,350 1,955 1,125
Total current assets 26,614 26,129 29,100 24,695
Property, plant, & equipment (PPE) 15,985 14,650 12,940 11,875
Intangible assets 5,500 2,855 2,000 1,855
Goodwill 24,500 20,066 17,750 16,486
Other noncurrent assets (inc. equity investment)* 11,350 9,125 7,955 6,820
Total noncurrent assets 57,335 46,696 40,645 37,036
*Investment in associate (25% stake) 6,355 6,000 4,825 3,500
Total assets 83,949 72,825 69,745 61,731
Accounts payable 9,850 8,950 7,825 6,450
Current portion of long-term debt 17,250 11,950 13,000 9,825
Other current liabilities 3,000 3,265 4,520 3,500
Total current liabilities 30,100 24,165 25,345 19,775
Long-term debt 4,044 4,655 5,800 7,211
Pension obligations and restructuring provisions 7,550 6,455 6,600 6,320
Stockholders' equity 42,255 37,550 32,000 28,425
Total liabilities and equity 83,949 72,825 69,745 61,731
Vol 2-104
Selected Income Statement Information
20X4 20X3 20X2
Revenue 77,355 70,050 66,750

Cost of goods sold (COGS) 30,625 27,820 25,655
Purchases 31,334 27,515 26,510
Average daily cash expenditures 172.5 160.4 145.5
EBIT 12,665 11,525 10,555
EBT 11,655 10,570 9,645
Share of income from associate 950 790 725
Net income 11,250 9,150 8,150
Selected Cash Flow Statement Information
20X4 20X3 20X2
CFO before interest and taxes 16,035 13,210 11,860

Cash interest paid 595 480 365
Cash taxes paid 2,620 2,455 2,250
Operating cash flow 12,820 10,275 9,245
Investing cash flow −13,900 −9,130 −4,135
Some aspects of Alpha's performance and operations that will be examined are as follows:
y What are Alpha's sources of earnings growth, how sustainable are its earnings, and do these earnings
reflect economic reality?
y What is the relationship between earnings and cash flow?
y Can the company's capital structure support its future operations and strategic plans?
y Does the balance sheet reflect all the rights and obligations of the company?
In order to answer these questions, analyses will be applied to Alpha's:
y DuPont decomposition
y Asset base
y Capital structure
y Segments and capital allocation across those segments
y Evaluation of earnings quality (through a study of the company's accruals)
y Decomposition of cash flows and an evaluation of their strategic adequacy
y Company valuation
Vol 2-105
Learning Module 6
DuPont Analysis
LOS: Identify financial reporting choices and biases that affect the quality and comparability of
companies' financial statements and explain how such biases may affect financial decisions.
DuPont decomposition isolates the components that affect a company's return on equity (ROE). This helps
us identify factors that drive a company's earnings and, at the same time, highlights weaker areas. The
five-way DuPont decomposition is shown in Exhibit 3:
Exhibit 3 DuPont analysis
Return on equity
Net income
Average shareholder’s equity
Return on assets Leverage

Net income Average total assets
×
Average total assets Average shareholder’s equity
Net profit margin Total asset turnover
Net income Revenue

×
Revenue Average total assets
Tax burden Interest burden EBIT margin

Net income EBT EBIT
× ×
EBT EBIT Revenue
NI EBT EBIT Revenue Average assets

ROE = × × × ×
EBT EBIT Revenue Average assets Average equity
EBT = Earnings before tax EBIT margin = Profitability

EBIT = Earnings before interest and taxes Total asset turnover = Efficiency
Vol 2-106
This granular approach isolates each component's effect on ROE and enables identification of relatively weak
areas of operations whose adverse impact on ROE may be masked by other, stronger areas. For example,
steady improvement in a company's ROE might be driven primarily by a rising net profit (NP) margin that
masks a declining asset turnover ratio. In that situation, breaking down ROE into its different components
would highlight weaker areas that management should focus on to improve the company's performance.
Note that Alpha records an investment in an associate (20X4: $6,355) on its balance sheet and a share
of income from that associate (20X4: $950) on the income statement. This indicates that Alpha uses the
equity method to account for its investment in the associate. In order to focus on Alpha's asset base and
the profitability of its core operations, remove the impact of the associate on Alpha's reported performance
using two adjustments:
y Remove the value of this equity investment from Alpha's total assets to focus exclusively on
the asset base.
○ This adjustment results in an improvement in asset turnover.
y Remove the share of the associate's net income from Alpha's reported net income to focus exclusively
on Alpha's profitability.
○ This adjustment results in a decline in the NP margin.
Based on the information provided in Exhibit 2, decompose Alpha's ROE as follows:
Exhibit 4 DuPont decomposition for Alpha, including investment in associate
Income Statement Information
20X4 20X3 20X2
Revenue 77,355 70,050 66,750

EBIT 12,665 11,525 10,555
EBT 11,655 10,570 9,645
Income from associate 950 790 725
Net income 11,250 9,150 8,150
Balance Sheet Information
20X4 20X3 20X2 20X1
Total assets 83,949 72,825 69,745 61,731

Investment in associate 6,355 6,000 4,825 3,500
Stockholders' equity 42,255 37,550 32,000 28,425
Extended DuPont Analysis
Interest Total asset Financial

Tax burden burden EBIT margin NP margin turnover leverage ROE
20X2 84.50% 91.38% 15.81% 12.21% 1.0154 2.1759 26.98%
20X3 86.57% 91.71% 16.45% 13.06% 0.9827 2.0499 26.31%
20X4 96.53% 92.03% 16.37% 14.54% 0.9868 1.9645 28.19%
Vol 2-107
Learning Module 6
In order to evaluate the company's performance on a stand-alone basis, the effects of its investment in the
associate must be removed:
Exhibit 5 DuPont decomposition for Alpha, excluding investment in associate
Extended DuPont Analysis

Interest Total asset Financial
Tax burden burden EBIT margin NP margin turnover leverage ROE
20X2 76.98% 91.38% 15.81% 11.12% 1.0840 2.1759 26.24%
20X3 79.09% 91.71% 16.45% 11.93% 1.0634 2.0499 26.02%
20X4 88.37% 92.03% 16.37% 13.32% 1.0713 1.9645 28.02%
Note that the financial leverage ratio has not been recalculated after excluding the investment in the
associate since no information was provided about the investment's financing. The implicit assumption is
that the mix of debt and equity used to finance the investment in the associate is similar to the pre-existing
capital structure of the parent.
Analysis:
y An upward trend is shown in Alpha's net profit margin, both with and without the associate. However,
there has been a slight increase in the contribution of the associate to Alpha's aggregate profit margin.
The associate contributed 1.22% (= 14.54 − 13.32) to Alpha's overall profit margin in 20X4, up from
1.09% (= 12.21 − 11.12) in 20X2.
y The financial leverage ratio decreased over the period. Even though this trend in the ratio slowed the
improvement in ROE, it has lowered the financial risk inherent in Alpha.
y The tax burden and interest burden ratios increased, which implies that the impact of taxes and interest
charges on operating earnings decreased. This contributed to the improving ROE over the period.
Vol 2-108
Asset-Base Composition
In order to identify and evaluate any changes in the composition of Alpha's balance sheet, examine its
common-size balance sheet:
Exhibit 6 Composition of total assets
20X4 20X3 20X2
Cash and cash equivalents 5.38% 5.15% 4.80%

Marketable securities 2.62% 6.25% 11.83%
Accounts receivable 14.23% 14.83% 13.71%
Inventories 7.60% 7.79% 8.57%
Other current assets 1.86% 1.85% 2.80%
Total current assets 31.70% 35.88% 41.72%
PPE 19.04% 20.12% 18.55%
Intangible assets 6.55% 3.92% 2.87%
Goodwill 29.18% 27.55% 25.45%
Other noncurrent assets 13.52% 12.53% 11.41%
Total noncurrent assets 68.30% 64.12% 58.28%
Analysis:
y The increasing shares of goodwill and intangibles in total assets indicate that Alpha has grown
through acquisitions.
y Acquisition activity can be confirmed by examining cash flow from investing activities in the statement
of cash flows. The substantial increase in cash outflow from investing activities over the period
indicates that the company has been investing in acquisitions and other noncurrent assets.
Vol 2-109
Learning Module 6
Capital Structure Analysis
Percentage changes reflected in the long-term liabilities and equity section of the common-size balance
sheet are shown in Exhibit 7.
Exhibit 7 Percentage of long-term capital structure
20X4 20X3 20X2

Long-term debt 7.51% 9.57% 13.06%
Pension obligations and restructuring provisions 14.02% 13.27% 14.86%
Stockholders' equity 78.47% 77.17% 72.07%
Total long-term capital 100% 100% 100%
The significant changes here—the increased proportion of equity and the decreased proportion of debt—
supported the decrease in financial leverage. Other long-term debts have remained steady, and the
financial risk inherent in long-term debt obligations is greater than the risk associated with pension plan
obligations/restructuring provisions. Thus, there has been an overall reduction of risk in the capital structure.
Given that the company's long-term liabilities are decreasing, check that there are no offsetting changes in
working capital accounts.
Exhibit 8 Selected working capital accounts and ratios
20X4 20X3 20X2 20X1
Cash and cash equivalents 4,520 3,750 3,350 3,500

Marketable securities 2,200 4,554 8,250 7,120
Accounts receivable 11,950 10,800 9,565 7,825
Inventories 6,384 5,675 5,980 5,125
Other current assets 1,560 1,350 1,955 1,125
Current assets 26,614 26,129 29,100 24,695
Accounts payable 9,850 8,950 7,825 6,450
Current portion of long-term debt 17,250 11,950 13,000 9,825
Other current liabilities 3,000 3,265 4,520 3,500
Current liabilities 30,100 24,165 25,345 19,775
Vol 2-110
Other data 20X4 20X3 20X2
Revenue 77,355 70,050 66,750

COGS 30,625 27,820 25,655
Purchases 31,334 27,515 26,510
Average daily expenditures 172.50 160.40 145.50
Working capital ratios 20X4 20X3 20X2
Current ratio 0.88 1.08 1.15

Quick ratio 0.62 0.79 0.84
Defensive interval ratio 108.23 119.10 145.46
Days sales outstanding (DSO) 53.67 53.06 47.55
Days inventory on hand (DOH) 71.86 76.46 79.00
Days payables 109.50 111.26 98.27
Cash conversion cycle 16.04 18.25 28.27
Defensive interval ratio = (Cash + Marketable securities + Accounts

receivable) / Daily cash expenditures
Defensive interval ratio = (4,520 + 2,200 + 11,950) / 172.5 = 108.23
The current ratio and quick ratio decreased over the period due to a significant increase in the current
portion of long-term debt and a decrease in marketable securities. Those changes, coupled with the
increase in daily cash expenditure, decreased the defensive interval ratio. The company does show
an improved cash conversion cycle with quicker inventory turnover (ie, DOH decreased) and slower
payables turnover (ie, days payables increased), which are signs of better cash management. However,
receivables turnover decreased (ie, DSO increased)—indicating that management of customer credit is
becoming more lax.
Vol 2-111
Learning Module 6
Segment Analysis and Earnings
LOS: Evaluate how a given change in accounting standards, methods, or assumptions affects
Analysis of geographical segments enables us to identify the segments of greatest importance to

a company, and to understand any geopolitical investment risks the company faces. Alpha has five
geographical segments; revenue and EBIT information for those segments is presented in Exhibit 9:
Exhibit 9 Segment revenue and EBIT information
Revenue by Segment
20X4 % Total 20X3 % Total 20X2 % Total
North America 9,125 11.80% 6,250 8.92% 5,525 8.28%

Europe 31,565 40.81% 29,850 42.61% 27,625 41.39%
Asia 18,950 24.50% 16,860 24.07% 16,955 25.40%
Africa 7,800 10.08% 6,955 9.93% 6,350 9.51%
Australia 9,915 12.82% 10,135 14.47% 10,295 15.42%
77,355 100.00% 70,050 100.00% 66,750 100.00%
EBIT by Segment
20X4 % Total 20X3 % Total 20X2 % Total
North America 2,250 17.77% 2,075 18.00% 1,975 18.71%

Europe 5,150 40.66% 4,655 40.39% 4,285 40.60%
Asia 2,515 19.86% 2,150 18.66% 1,850 17.53%
Africa 1,540 12.16% 1,375 11.93% 1,170 11.08%
Australia 1,210 9.55% 1,270 11.02% 1,275 12.08%
12,665 100.00% 11,525 100.00% 10,555 100.00%
Segment revenue shows that the proportions of sales and EBIT from Africa increased, while the proportions
from Asia and Europe held relatively steady and those from Australia decreased. Revenues from North
America have grown, but its share of EBIT has not kept pace, indicating that margins in North America
may be shrinking.
Vol 2-112
Cash Flow and Capital
In order to evaluate the company's assets and capital allocation decisions, use the segment EBIT information
provided in Exhibit 9 and the asset and capital expenditure distribution in Exhibit 10 to construct Exhibit 11.
Exhibit 10 Asset and capital expenditure segment information
Assets 20X4 20X3 20X2

North America 18,470 22.00% 11,950 16.41% 10,760 15.43%
Europe 24,150 28.77% 23,450 32.20% 22,500 32.26%
Asia 16,899 20.13% 15,865 21.79% 15,560 22.31%
Africa 12,605 15.02% 11,160 15.32% 10,825 15.52%
Australia 11,825 14.09% 10,400 14.28% 10,100 14.48%
83,949 72,825 69,745
Capital expenditures 20X4 20X3 20X2

North America 395 9.84% 350 9.97% 255 8.69%
Europe 1,275 31.76% 1,225 34.90% 1,150 39.18%
Asia 835 20.80% 660 18.80% 625 21.29%
Africa 740 18.43% 630 17.95% 425 14.48%
Australia 770 19.18% 645 18.38% 480 16.35%
4,015 3,510 2,935
Exhibit 11 EBIT margin ranking vs. CAPEX %-to-assets % (CA%) ratio
EBIT Margin CA%

20X4 20X4 20X3 20X2
North America 24.66% 0.45 0.61 0.56
Africa 19.74% 1.23 1.17 0.93
Europe 16.32% 1.10 1.08 1.21
Asia 13.27% 1.03 0.86 0.95
Australia 12.20% 1.36 1.29 1.13
Vol 2-113
Learning Module 6
Evaluating the CA% ratio
y A ratio > 1 indicates that the company is allocating a higher proportion of its capital expenditures to
the segment than its proportion of total assets. If this trend continues, the segment will become more
significant over time.
y A ratio = 1 indicates that the segment's allocated proportion of capital expenditures is equal to its
proportion of total assets.
y A ratio < 1 indicates that the company is not prioritizing the segment, and it will likely become less
significant over time.
In Exhibit 10, the segments are listed according to their EBIT margins, from highest to lowest. The table
also includes the CA% ratio for the segments from 20X2 to 20X4.
Analysis:
y Although the North American segment has the highest EBIT margin, Alpha has not been investing
aggressively in the segment (indicated by a CA% ratio that is significantly lower than 1).
y Alpha has invested aggressively in Australia (indicated by a CA% ratio that is well above 1), even
though this segment has the lowest EBIT margin and declining sales.
y For the African, European, and Asian segments:
○ The African segment has the highest EBIT margin, so its CA% ratio is higher than the other two.
○ The Asian segment has the lowest EBIT margin, so its CA% ratio is lower than the other two.
Given that Alpha has made a number of acquisitions, examine the relationship between its operating cash
flow and total assets:
Exhibit 12 Operating cash flow to total assets
20X4 20X3 20X2

Average total assets 78,387 71,285 65,738
Operating cash flow / Average total assets 16.35% 14.41% 14.06%
The cash return on total assets has increased over time, which justifies Alpha's recent acquisitions.
Vol 2-114
Earnings Quality
In order to determine the sustainability of a company's earnings, evaluate the quality of its reported earnings
by examining its balance sheet-based accruals and cash flow statement-based accruals. The higher the
proportion of a company's earnings that are based on accruals, the lower the quality of earnings.
Selected information from Alpha's balance sheets and cash flow statements is presented in Exhibit 12.
Exhibit 13 Selected balance sheet and cash flow information
Balance Sheet 20X4 20X3 20X2 20X1
Total assets 83,949 72,825 69,745 61,731

Less: Cash and marketable securities 6,720 8,304 11,600 10,620
Operating assets (A) 77,229 64,521 58,145 51,111
Total liabilities 41,694 35,275 37,745 33,306
Less: Long-term debt 4,044 4,655 5,800 7,211
Less: Short-term debt 17,250 11,950 13,000 9,825
Operating liabilities (B) 20,400 18,670 18,945 16,270
Net operating assets (NOA = A − B) 56,829 45,851 39,200 34,841
Balance sheet accruals (change in NOA) 10,978 6,651 4,359
Cash flow statement 20X4 20X3 20X2
Net income 11,250 9,150 8,150

Less: Operating cash flow 12,820 10,275 9,245
Less: Investing cash flow −13,900 −9,130 −4,135
Cash flow accruals 12,330 8,005 3,040
In order to put a change in accruals in perspective, look at it as a percentage of average accruals:
(NOAt − NOAt−1)
Accrual ratio (balance sheet approach) =
(NOAt + NOAt−1)
� �
2
Vol 2-115
Learning Module 6
NIt − (CFOt − CFIt)

Accrual ratio (cash flow approach) =
(NOAt + NOAt−1)
� �
2
Exhibit 14 Accruals ratios
Accruals Ratios 20X4 20X3 20X2
Balance sheet approach 21.38% 15.64% 11.77%

Cash flow approach 24.02% 18.82% 8.21%
Increased accruals ratios, as seen in Exhibit 14, indicate that earnings quality is deteriorating.
Cash Flow Relationships
To investigate further, evaluate the relationship between Alpha's cash flows and its earnings. Specifically,
compare operating cash flow (OCF) before interest and taxes to operating income adjusted for
accounting changes.
Exhibit 15 Operating cash flow to operating income
20X4 20X3 20X2

Cash taxes paid 2,620 2,455 2,250
OCF before interest and taxes 16,035 13,210 11,860
Operating income (EBIT) 12,665 11,525 10,555
OCF before interest and taxes / EBIT 1.27 1.15 1.12
Since OCF before interest and taxes exceeds operating income, some of the concern about earnings
management is alleviated.
Vol 2-116
To remove any lingering doubt regarding the earlier analysis of accruals, assess the relationship between
Alpha's cash flow, reinvestment, and debt, as well as its debt-servicing capacity:
Exhibit 16 Operating cash flow to reinvestment, debt, and cash flow interest coverage
20X4 20X3 20X2

Cash flow to reinvestment
Operating cash flow (OCF) 12,820 10,275 9,245
Capital expenditures 4,015 3,510 2,935
OCF / Capital expenditures 3.19 2.93 3.15
Cash flow to total debt
Total debt 21,294 16,605 18,800
Total debt equals total long-term debt (inc. current

portion), but it does not include pension obligations
and restructuring provisions.
OCF before interest and taxes / Total debt 75.30% 79.55% 63.09%
Cash flow interest coverage
OCF before interest and taxes / Cash interest 26.95 27.52 32.49
Alpha's reinvestment needs are covered by OCF by a factor of 3.19, which suggests that the company has
ample resources for its reinvestment program. The OCF-to-CAPEX ratio has not changed much despite the
increase in capital expenditures over the three years, showing that the company can generate enough cash
flow to support the increased assets needed to support growth.
The cash flow-to-total debt ratio (75.3%) shows that Alpha has the capacity to pay off its debt in
approximately 2.5 years [= 21,294 / (12,820 − 4,015)] while maintaining its current reinvestment policy.
Although the interest coverage ratio has declined, it is still quite high. The company's annual cash flow is
enough to cover annual interest payments by a factor of 26.95 times, which also suggests that the company
has the financial capacity to add more debt to its capital structure should it need to raise funds.
Vol 2-117
Learning Module 6
Decomposition and Analysis of the Company's Valuation
Since Alpha holds an equity investment (but not a controlling share) in an associate, remove the effects of
this holding from Alpha's market value in order to evaluate the market value.
Assume that the market capitalizations of Alpha and its associate are $175 million and $40 million,
respectively. Since Alpha has a 25% equity interest in the associate, its pro rata share of the associate's
market value is $10 million (= 25% × 40 million). Removing the value of this investment from Alpha's overall
market value gives Alpha an implied market value of $165 million.
Alpha's 20X4 trailing P/E ratio, based on its implied value ($165 million) and earnings adjusted for the
income from associates (11.25 − 0.95 = $10.3 million), is 16.02. Given a trailing P/E multiple of 19.5 for the
benchmark index, we conclude that Alpha (excluding its investment in the associate) is undervalued, and is
trading at a 17.85% discount.
Conclusions and Follow-Up
Support for an Investment in Alpha's Shares

y Alpha's growth in earnings has been achieved through internal operations, acquisitions, and its equity
investment in an associate company.
y The company has sufficient cash flows to finance future operating costs, capital expenditures,
and investments.
y The company has the capacity to obtain additional debt financing.
y The company's ROE has shown an upward trend. The associate has contributed to the increase in
ROE but has not been the primary driver of earnings.
y The company's operating cash flows have consistently exceeded operating earnings, indicating a high
quality of earnings.
y The cash return on total assets has been increasing consistently.
y An assessment of the company's implied value and trailing P/E ratio indicates that its shares are
relatively undervalued.
Vol 2-118
Causes for Concern

y The increase in both balance sheet-based and cash flow-based accruals ratios raises concerns
regarding earnings manipulation. However, these concerns are alleviated by the company's strong
cash flow position.
y Alpha's allocation of capital expenditures across geographical segments is inconsistent with the
segments' growth and contribution to earnings: The company over-allocates capital resources to the
lowest-margin segment (Australia) and underinvests in the highest-margin segment (North America).
y Impairment of goodwill in the future may cause losses to the company. Goodwill currently comprises
almost 30% of Alpha's total assets.
Vol 2-119
Learning Module 6
Vol 2-120
Learning Module 7
Financial Statement Modeling
LOS: Compare top-down, bottom-up, and hybrid approaches for developing inputs to equity
valuation models.
LOS: Compare “growth relative to GDP growth” and “market growth and market share”
approaches to forecasting revenue.
LOS: Evaluate whether economies of scale are present in an industry by analyzing operating
margins and sales levels.
LOS: Demonstrate methods to forecast cost of goods sold and operating expenses.
LOS: Demonstrate methods to forecast nonoperating items, financing costs, and income taxes.
LOS: Describe approaches to balance sheet modeling.
LOS: Demonstrate the development of a sales-based pro forma company model.
LOS: Explain how behavioral factors affect analyst forecasts and recommended remedial
actions for analyst biases.
LOS: Explain how competitive factors affect prices and costs.
LOS: Evaluate the competitive position of a company based on Porter’s five forces analysis.
LOS: Explain how to forecast industry and company sales and costs when they are subject to
price inflation or deflation.
LOS: Evaluate the effects of technological developments on demand, selling prices, costs,
and margins.
LOS: Explain considerations in the choice of an explicit forecast horizon.
LOS: Explain an analyst’s choices in developing projections beyond the short-term

forecast horizon.
Vol 2-121
Learning Module 7
Introduction
LOS: Compare top-down, bottom-up, and hybrid approaches for developing inputs to equity
valuation models.
LOS: Compare “growth relative to GDP growth” and “market growth and market share”
approaches to forecasting revenue.
An effective financial statement model must be based on a thorough understanding of a company’s

business, management, strategy, external environment, and historical results. In order to identify a
company’s key revenue and cost drivers, an analyst must comprehend both the company and its industry.
The basis for forecast model inputs is the understanding of fundamental drivers.
Financial Statement Modeling: An Overview

Financial statement modeling generally begins with the income statement since the value of most entities
(except possibly for banks and insurance companies) is driven primarily by future operating income
generated by the business.
Income Statement Modeling: Revenue

Companies can report revenues by geographical source, business segment, or product line. Geographical
analysis may be useful for companies operating in multiple countries or regions with different underlying
growth rates or competitive dynamics. Both IFRS and US GAAP require issuers to disclose financial
information for any operating segment whose revenue, operating income, or assets account for 10% or
more of consolidated results. This requirement is especially helpful to analysts working across industries or
markets with widely different economics.
Product line analysis provides a more granular level of detail and is helpful if the company has a
manageably small number of products, each with different behavior. A top-down approach usually begins
at the level of the overall economy followed by sector, industry, and market for each product. A bottom-up
approach begins with product lines, locations, or business segments and builds up to the total revenue
forecast. A hybrid approach combines elements of top-down and bottom-up analysis and can be useful for
uncovering implicit assumptions or errors that may arise from using a single approach.
Top-Down Approaches to Modeling Revenue

Two common top-down approaches to modeling revenue are “growth relative to GDP growth” and “market
growth and market share.”
Growth relative to GDP growth: The analyst first forecasts the growth rate of nominal GDP, then considers
how the growth of the specific company will compare with nominal GDP growth. The analyst could also
forecast volume based on an estimated relationship between real GDP, inflation, and price. Depending on
which stage of the company’s and industry’s life cycle (ie, embryonic, growth, shakeout, mature, or decline)
is relevant, the analyst may add a percentage premium or discount to the GDP growth rate or use a multiple
of GDP growth rate.
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Market growth and market share: The analyst uses an estimate of growth in a particular market, then
forecasts the change in the company’s current market share. For example, if a company’s market share is
currently 10% but is expected to increase to 12% while the market grows from EUR 150 billion to EUR 170
billion, the company’s revenues are forecasted as growing from EUR 15 billion (10% × 150) to EUR 20.4
billion (12% × 170).
Bottom-Up Approaches to Modeling Revenue

Examples of bottom-up approaches to modeling revenue include:
y Time series: The analyst’s forecasts are based on historical growth rates or time series analysis. This
is the simplest approach, in which historical trends are expected to continue.
y Return-based measure: The analyst bases forecasts on balance sheet accounts. For example,
forecasted interest revenue for a bank can be based on loans and an average interest rate, while
predicted interest expense is based on debt and an average interest rate.
y Capacity-based measures: In this approach, forecasts are based on asset turnover, existing assets,
and expected investment in assets. For instance, retail sales may be based on sales per square foot
and square footage available.
Hybrid Approaches to Modeling Revenue

Hybrid approaches mix elements of top-down and bottom-up models. For instance, market growth and
market share could be used to model individual product lines or business segments, which are then
aggregated to arrive at a forecast for the overall company. Depending on how these elements are forecast,
the approach may be classified as top-down, bottom-up, or hybrid.
Income Statement Modeling: Operating Costs
LOS: Evaluate whether economies of scale are present in an industry by analyzing operating
margins and sales levels.
Analysts may derive cost projections from revenue forecasts, given margins in various product lines
and segments. In a top-down approach, the analyst might consider factors such as inflation or industry-
specific costs before making assumptions about the individual company. In a bottom-up approach, the
analyst would start with segment-level margins, historical cost growth rates, historical margin levels, or the
costs of delivering specific products. A hybrid approach, of course, would incorporate both top-down and
bottom-up elements.
Fixed costs are independent of revenues and therefore must be projected independently. Analysts should
pay particular attention to economies of scale (ie, average cost per unit falling as volume rises). Gross
margins and operating margins tend to be positively correlated with sales levels in an industry that has
economies of scale. Factors that lead to economies of scale include high fixed costs, increased levels of
production, greater bargaining power with suppliers, and lower per-unit advertising expenses.
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Modeling Operating Costs: Cost of Goods Sold and SG&A
LOS: Demonstrate methods to forecast cost of goods sold and operating revenues.
Cost of goods sold (COGS) is directly linked with sales, so forecasting this item as a percentage of sales is
generally a good idea. Since COGS as a percentage of sales varies inversely with gross margin, historical
margins are a useful starting point, but they may need to be adjusted. For example, if the company is losing
market share in a market where the emergence of new substitute products is pressuring prices, the analyst
may adjust forecasted gross margins downward from historical trends. In contrast, if the company is gaining
market share due to new competitive, innovative products with cost advantages, gross margins should be
forecast to expand.
As COGS is typically a significant cost, even small errors in the forecast can have material impacts on
the operating profit. It is best to find ways to make this forecast as precise as possible, using segments or
product categories.
Analysts should also consider the hedging strategies for key input costs such as commodities; while
companies usually do not disclose their hedging positions, a general strategy is often revealed in the
footnotes of the annual reports.
SG&A Expenses
Sales, general, and administrative (SG&A) expenses have a weaker relationship to revenues than COGS.
If the different elements of SG&A are disclosed, the analyst can ascertain which of them (eg, selling and
distribution) are more closely related to revenues. Other expenses, such as overhead, may be more fixed.
In addition to analyzing the historical relationship between a company’s operating expenses and sales,
benchmarking a company against its competitors can be useful. A forecast model may also include cross-
checks, such as comparisons to see if square footage in the revenue forecast matches square footage in
the expense forecast. Sales and expense projections can be refined and improved if the company provides
breakouts of product and/or geographic segments in the footnotes of its annual report.
Modeling Nonoperating Costs and Other Items
LOS: Demonstrate methods to forecast nonoperating items, financing costs, and income taxes.
Line items on the income statement that appear below operating profit—such as interest income, interest
expense, income taxes, noncontrolling interest, income from affiliates, and shares outstanding—also need
to be modeled.
Financing Expenses
Financing expenses consist of interest income and interest expense; these items are generally netted.
Interest income is prevalent for banks, but less so for nonfinancial entities.
Interest expense is related to the amount of a company’s debt. Interest rates are not static, and changes in
rates can have a significant impact on the company’s interest expense and the market value of its debt.
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Corporate Income Tax

Income taxes are primarily determined by the geographic composition of profits and the tax rates in
each geographic area, but they can also be influenced by the nature of a business. For example, some
companies can benefit from special tax treatment for their investments in R&D.
There are three types of tax rates:
y The statutory tax rate is the corporate tax rate in the country where the firm is domiciled.
y The effective tax rate is the reported income tax expense as a percentage of pretax income.
y The cash tax rate is the tax actually paid as a percentage of pretax income.
Differences between cash taxes and reported taxes result from differences between tax accounting and
financial accounting and are reported as a deferred tax asset or a deferred tax liability.
Differences between the statutory tax rate and the effective tax rate can arise for many reasons, including
tax credits, withholding tax on dividends, adjustments to previous years, and expenses that are not
deductible for tax purposes.
Effective tax rates can differ when companies are active outside the country in which they are domiciled. In
such cases, the effective tax rate becomes a blend of the different tax rates where activities take place.
By building a model, analysts can find the effective tax amount in the profit/loss projections and the cash
tax amount on the cash flow statement (or given as supplemental information). The reconciliation between
the tax amounts for profit/loss and cash flow should be the change in the deferred tax asset and/or liability,
unless there are permanent differences between tax accounting and financial accounting.
Income Statement Modeling: Other Items

Analysts should model other items based on disclosures (eg, dividend policy) or information on
minority interests.
Share count (ie, shares issued and outstanding) is a key input to the calculation of earnings per share
(EPS). Share count can change due to dilution (through stock options, convertible bonds, and convertible
preferred shares), the issuance of new shares, share repurchases, or stock dividends. Projections for share
issuance and repurchases should fit within the analyst’s broader analysis of a company’s capital structure.
Unusual charges can be almost impossible to predict, especially beyond a few years. Analysts typically
exclude unusual charges from their forecasts.
Balance Sheet and Cash Flow Statement Modeling
LOS: Describe approaches to balance sheet modeling.
Income statement modeling is the starting point for balance sheet and cash flow statement modeling.
Some balance sheet items (eg, retained earnings) flow directly from the income statement, and others (eg,
accounts receivable, accounts payable, inventories) are very closely linked to income statement projections.
Efficiency ratios are a common way to model working capital line items. Working capital projections may
be modified using both top-down and bottom-up considerations. To begin, analysts can look at historical
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efficiency ratios and adjust them for current assumptions depending on expectations for sales, payments,
and collections.
Long-Term Assets and Liabilities

Long-term assets such as plant, property & equipment (PPE) and intangible assets are less directly tied to
the income statement and change primarily due to capital expenditures and depreciation and amortization.
Depreciation and amortization forecasts are generally based on historical depreciation and the levels of
long-term assets. Capital expenditure forecasts depend on analysts’ judgment of future capacity expansion,
driven by the business model and revenue growth. Capital expenditures are composed of both maintenance
capital expenditures and growth capital expenditures.
When forecasting debt and equity levels, leverage ratios such as debt-to-capital, debt-to-equity, and debt-
to-EBITDA are helpful. Analysts may also consider historical company practice, management’s financial
strategy, and capital requirements implied by other model assumptions.
Statement of Cash Flows

Once income statement and balance sheet projections have been constructed, future cash flow statements
can be projected. For these projections, it is helpful to have a good understanding of how statements of
cash flows are built using the direct and indirect methods. Projecting future cash flows also gives analysts
an opportunity to communicate and validate their assumptions regarding capital expenditures, dividends,
share repurchases, and the issuance of debt and new shares.
Building a Financial Statement Model
LOS: Demonstrate the development of a sales-based pro forma company model.
Dettifoss Industries is a fictional Icelandic company that primarily sells mead, an alcoholic beverage made
by fermenting honey. An analyst wants to build a financial statement model to value the company and its
equity. The analyst will focus primarily on the mechanics of constructing pro forma income statements,
balance sheets, and statements of cash flows. Data sources for this example include the company’s
annual reports for fiscal years ended Dec 31 20X2, 20X1, and 20X0; investor presentations; and quarterly
earnings calls.
Company Overview
Dettifoss Industries, whose reporting year ends on Dec 31, operates and reports four product lines:
y Hekla is a traditional brand of mead that represented 22% of total sales in 20X2.
y The Laki brand is similar to Hekla but mixed with apple cider. It represented 25% of total sales in 20X2.
y The highest sales come from the Askja brand, a mead mixed with cinnamon that represented 37% of
total sales in 20X2.
y The remaining sales (16%) came from the Eldfell brand, a mead mixed with hops.
Mead is typically produced in small quantities, close to the date and place of intended consumption.
Dettifoss Industries produces mead on demand from locales throughout Iceland, Norway, Denmark,
Sweden, and the United Kingdom, with its reporting currency being the Icelandic krona (ISK).
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Segment financial information is summarized in Exhibit 1. Although the Askja brand is the best seller, the
Hekla brand has the best operating margin due to lower operating costs from a simpler production process.
Exhibit 1 Selected segment financial data for Dettifoss Industries
Dettifoss Industries
20X0 20X1 20X2

(ISK millions)
Hekla 234.9 258.4 291.9
Laki 258.9 291.0 331.8
Askja 341.1 402.5 491.0
Eldfell 179.5 194.8 212.3
Revenues 1,014.4 1,146.7 1,327.0
Hekla 67.3 79.8 85.0

Laki 62.9 73.0 81.9
Askja 84.9 103.8 122.3

Eldfell 33.2 39.5 40.6
Operating profit 248.3 296.1 329.8
(% of revenues)
Hekla 28.7% 30.9% 29.1%
Laki 24.3% 25.1% 24.7%
Askja 24.9% 25.8% 24.9%
Eldfell 18.5% 20.3% 19.1%
Operating margin 24.5% 25.8% 24.9%
Revenue Forecast
Each product line consists of products sold in different containers and sizes. For example, mead from
each brand can be sold in cans (330 mL and 500 mL), bottles (330 mL and 750 mL), or kegs (5 liters
and 10 liters).
The revenue trends for each product line reflect all the products in that line and are driven by estimates of:
y Volume
y Price and product mix
y Foreign exchange rates
Despite discussions of a potential recession, the analyst anticipates that volume growth will remain strong
as mead is still a rather new niche product that represents only a small proportion of consumers’ income
and a small share in the overall consumption of alcoholic beverages. Furthermore, the analyst expects that
volume growth will be driven by word of mouth and that inflation can be passed along to consumers instead
of being absorbed through margins.
Exhibit 2 summarizes historical and projected information for the Askja segment.
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Exhibit 2 Historical and projected information for Askja product line
Askja product line
20X1 20X2 20X3E 20X4E 20X5E
Revenues (ISK millions) 402.5 491.0 589.0 692.0 807.0

Annual revenue growth 18.0% 22.0% 19.9% 17.5% 16.6%
Volume growth 11.3% 12.4% 10.0% 13.0% 13.0%
Price/mix 1.9% 3.4% 9.0% 4.0% 3.2%
Organic growth 13.4% 16.2% 19.9% 17.5% 16.6%
Forex impact 4.0% 5.0% 0.0% 0.0% 0.0%
Askja’s revenues from 20X0 to 20X2 are presented in Exhibit 1. Historical information for the bottom-up
revenue drivers (ie, volume growth and price/mix) is disclosed by the company.
Exhibit 2 shows that volume growth was above 10% in the last two years. The analyst expects growth to
remain strong in the next three years, with rates between 10% and 13%.
Historical price/mix has also increased, although more modestly than volume growth. The analyst expects
a 9% increase in 20X3—due to consumers’ opting for higher-priced products (eg, larger bottles) instead of
lower-priced products (eg, smaller cans)—and then a return to historical rates in the following years.
Organic growth is calculated as the product of the volume growth and price/mix rates. For example, the
organic growth of 16.2% for 20X2 is calculated as [(1 + 0.124) × (1 + 0.034)] − 1.
Note that the drivers are interconnected, so changing the way a driver is measured affects the other
driver(s). In this scenario, volume is measured in units sold, whether the unit is a can, bottle, or keg.
Therefore, the price/mix naturally increases when customers favor products sold in larger containers.
However, the company could also disclose the volume in terms of hectoliters sold. In that scenario, an
increased preference for larger containers would have a positive impact on the volume driver, but not on the
price/mix driver.
Dettifoss states that over 60% of revenues come from outside Iceland, so changes in exchange rates may
significantly affect revenue trends. In the absence of other known impacts (eg, scope changes such as
acquisitions or divestitures), the analyst assumes that the entire difference between organic growth and
revenue growth is forex impact, due to movements in exchange rates. For example, the forex impact of 5%
in 20X2 is estimated as [(1 + 0.22) / (1 + 0.162)] − 1.
The analyst knows that exchange rates are constantly fluctuating but does not expect any particular trend in
the projected years. Therefore, the analyst assumes a forex impact of zero for those years.
A similar analysis can be performed to project revenue for each product line (or segment or geographical
division, depending on the nature of the business and availability of information).
COGS
If the gross margin remained mostly flat within each division, it could still vary at the consolidated level
provided that there were variations in the revenue mix. Market consolidation and economies of scale can
also change the gross margin within each segment. Analysts’ forecasts should incorporate all these factors,
as well as management guidance.
In this case, COGS increased substantially in 20X1 due to an increase in the costs of raw materials, making
gross margin decrease from 80% to 78%. However, in the next year, despite a 16% increase in revenues,
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COGS remained stable as the costs of raw materials scaled back, and gross margin recovered to 81%.
The analyst believes that this downward trend in costs will persist and anticipates gross margin increasing
slightly to 83% until 20X6.
SG&A Expenses and Other Operating Expenses

Distribution costs have remained relatively stable as a percentage of revenues over time. The analyst
believes that Dettifoss should expand operations to the Americas or Southern Europe, which would cause
this line item to increase as a percentage of revenues. However, the company informed investors that its
current focus is to consolidate its expansion in Northern Europe, so the analyst keeps distribution costs as a
constant percentage of revenues.
After being relatively stable in 20X1 due to a sharp reduction in hiring and travel, administrative expenses
are expected to increase. The company plans to strengthen its legal and accounting departments to support
its growing operations in Northern Europe, and the tighter labor market is putting additional pressure on
salaries and benefits. The analyst assumes that administrative expenses will increase approximately in line
with revenues until 20X5 and at a slower rate from 20X6 on, decreasing 1 percentage point as a proportion
of revenues.
Exhibit 3 provides a partial income statement for Dettifoss Industries.
Exhibit 3 Selected income statement information for Dettifoss Industries
20X0 20X1 20X2 20X3E 20X4E 20X5E 20X6E

(ISK millions)
Revenues 1,014 1,147 1,327 1,573 1,851 2,158 2,488
COGS (203) (253) (252) (283) (329) (378) (423)
Gross profit 811 894 1,075 1,290 1,522 1,780 2,065
Gross margin 80.0% 78.0% 81.0% 82.0% 82.2% 82.5% 83.0%
Distribution costs (347) (378) (464) (546) (637) (755) (853)
(% of revenues) 34.2% 33.0% 35.0% 34.7% 34.4% 35.0% 34.3%
Admin. expenses (216) (220) (281) (330) (383) (451) (495)
(% of revenues) 21.3% 19.2% 21.2% 21.0% 20.7% 20.9% 19.9%
EBIT 248 296 330 414 502 574 717
EBIT margin 24.5% 25.8% 24.9% 26.3% 27.1% 26.6% 28.8%
The analyst could also use a segment approach to estimate the current operating profit (a non-IFRS
measure) of each of Dettifoss’s product lines. The sum of the current operating profit of the four product
lines and the costs at the corporate or holding level must equal the consolidated EBIT from Exhibit 3. This
approach can be used as an alternative or as a “check” to the consolidated approach.
Nonoperating Items
The analyst includes three nonoperating items when building Dettifoss’s model: net finance cost, income
tax, and shares outstanding.
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Net Finance Cost
Interest expense (on debt)

− Interest income (on cash and investments)
Net finance cost
To forecast net finance cost, the analyst would first need an estimate of debt and cash positions as well as
interest rates paid and earned. As seen in Exhibit 4, Dettifoss’s gross debt has increased in the last few
years, and the analyst expects debt to remain stable for the upcoming period. Dettifoss pays a fixed interest
rate of 2.6% on gross debt; this rate is estimated to remain steady through 20X6. The analyst forecasts
interest expense by applying the interest rate to the beginning balance of gross debt.
Interest income is usually calculated after forecasting the statement of cash flows and estimating the cash
position. However, the analyst knows that Dettifoss tends to maintain its cash in very liquid assets that
generate negligible yields. Therefore, the analyst estimates no interest income for the forecasted period and
net finance cost equal to interest expense.
Exhibit 4 Debt position and net finance cost for Dettifoss
20X0 20X1 20X2 20X3E 20X4E 20X5E 20X6E

(ISK millions)
Long-term debt 1,457 1,581 1,830 1,860 1,860 1,860 1,860
Short-term debt 120 150 170 140 140 140 140
Gross debt 1,577 1,731 2,000 2,000 2,000 2,000 2,000
Interest rate 2.6% 2.6% 2.6% 2.6% 2.6% 2.6%
Interest expense 40 41 45 52 52 52 52
Interest income 0 0 0 0 0 0 0
Net finance cost 40 41 45 52 52 52 52
Corporate Income Tax Forecast

The relevant statutory tax rate at the time of analysis is 20%, and the company’s effective tax rate has been
close to the statutory rate over the last few years. Therefore, an estimated 20% effective tax rate is used for
the forecasted period.
Shares Outstanding
Shares outstanding are used to calculate earnings per share (EPS). They can be disclosed as basic shares
outstanding or as fully diluted shares outstanding. Both forms are calculated using weighted averages
throughout the year.
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Exhibit 5 Shares outstanding for Dettifoss
20X0 20X1 20X2

(ISK millions)
Beginning basic shares outstanding 37.8 39.0 39.7
Share repurchases (0.2) (0.4) (0.4)
Share issuance 1.4 1.1 0.1
Ending basic shares outstanding 39.0 39.7 39.4
Weighted average basic shares 38.4 39.4 39.6
Dilutive securities 0.6 4.5 4.5
Weighted average diluted shares 39.0 43.9 44.1
The company does not pay significant share-based compensation, nor has it issued or repurchased
significant numbers of shares over the last few years, so the number of outstanding shares has not
changed materially. The analyst decides to assume that average basic and fully diluted shares outstanding
on the income statement will remain at 20X2 levels.
Pro Forma Income Statement

With the forecast components in place, the analyst can now build a consolidated pro forma income
statement. Dettifoss did not discontinue operations nor recognize income from associates during the
historical period. The analyst assumes that this will continue for the projected period.
Exhibit 6 Consolidated historical and projected income statement for Dettifoss
20X0 20X1 20X2 20X3E 20X4E 20X5E 20X6E

(ISK millions)
Revenues 1,014 1,147 1,327 1,573 1,851 2,158 2,488
COGS (203) (253) (252) (283) (329) (378) (423)
Gross profit 811 894 1,075 1,290 1,522 1,780 2,065
Distribution costs (347) (378) (464) (546) (637) (755) (853)
Admin. expenses (216) (220) (281) (330) (383) (451) (495)
EBIT 248 296 330 414 502 574 717
Interest expense (40) (41) (45) (52) (52) (52) (52)
Interest income 0 0 0 0 0 0 0
Net finance cost (40) (41) (45) (52) (52) (52) (52)
Profit before tax 208 255 285 362 450 522 665
Income tax (46) (46) (57) (72) (90) (104) (133)
Net income 162 209 228 290 360 418 532
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20X0 20X1 20X2 20X3E 20X4E 20X5E 20X6E

(Millions)
Avg. basic shares 38.4 39.4 39.6 39.6 39.6 39.6 39.6
Avg. diluted shares 39.0 43.9 44.1 44.1 44.1 44.1 44.1
(ISK)
EPS basic total 4.23 5.31 5.76 7.31 9.10 10.56 13.46
EPS diluted total 4.16 4.77 5.17 6.57 8.17 9.48 12.08
Pro Forma Statement of Cash Flows
Exhibit 7 Projecting the statement of cash flows
To forecast the cash flow from: The analyst needs to estimate:
Net income
Operations (CFO) Share-based compensation
Working capital
Depreciation and amortization

Investing (CFI)
Capital expenditures
Share repurchase and issuance
Financing (CFF) Dividends
Debt issuance and repayment
Forecasting the statement of cash flows typically requires additional estimates, presented in Exhibit 7. The
analyst already estimated the net income in the projected income statement and estimated the net debt
issuance (ie, debt issued less repaid) when estimating the interest expense.
Note that the analyst needs the historical, rather than the projected, balance sheet to estimate some of
these items and forecast the cash flow statement, so the projected balance sheet can be forecasted after
the cash flow.
Capital Investments and Depreciation Forecasts

Capital investment (or CAPEX) was 7% of revenue in 20X2, and the analyst expects it to fall to 6% during
the forecast period. The analyst estimates that depreciation expenses will continue at 5% of the previous
year’s net PPE (ie, fixed assets net of depreciation), increasing in line with the higher asset base.
The model calculates that Net PPE = Previous year’s net PPE + CAPEX − Depreciation expenses.
Intangibles and amortization of intangibles are negligible during the historical period, so the analyst does
not consider them in the projections.
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Exhibit 8 CAPEX, depreciation, and amortization breakdowns for Dettifoss
(ISK millions) 20X0 20X1 20X2 20X3E 20X4E 20X5E 20X6E
CAPEX 62 80 93 106 120 135 149

As % of revenues 6.1% 7.0% 7.0% 6.8% 6.5% 6.3% 6.0%
Net PPE 1,720 1,711 1,719 1,739 1,773 1,819 1,877
Depreciation 71 89 85 86 87 89 91
As % of prior year PPE 5.2% 5.0% 5.0% 5.0% 5.0% 5.0%
Working Capital Forecasts

The working capital ratios were relatively stable from 20X0 to 20X2. The analyst assumes that the ratios will
remain similar to what the company experienced in 20X2. Therefore, throughout the forecast period:
y Days of inventory on hand = 71

y Days sales outstanding = 28
y Days payables outstanding = 65
Exhibit 9 Working capital development for Dettifoss
(ISK millions) 20X0 20X1 20X2 20X3E 20X4E 20X5E 20X6E
Inventory 40 48 49 55 64 74 82
Accounts receivable 85 89 102 121 142 166 191
Accounts payable 36 46 45 50 59 67 75
Working capital, net 89 91 106 125 147 172 198
% of sales 8.8% 7.9% 8.0% 8.0% 8.0% 8.0% 8.0%
Change (YoY) (2) (15) (19) (22) (24) (26)
(Number of days)
Days inventories on hand 71.9 69.4 70.9 71.0 71.0 71.0 71.0
Days sales outstanding 30.6 28.3 28.1 28.0 28.0 28.0 28.0
Days payables outstanding 64.7 66.5 65.1 65.0 65.0 65.0 65.0
Forecasted Cash Flow Statement

Up to this point, the analyst has estimated net income, depreciation and amortization, change in working
capital, and CAPEX and debt—most of the items required to forecast cash flow as listed in Exhibit 7. When
estimating shares outstanding, the analyst assumed that the company would not pay significant share-
based compensation or issue/repurchase shares during the forecast period. Therefore, only payment of
dividends needs to be estimated.
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The analyst knows that Dettifoss’s historical dividend policy is to distribute 50% of net income annually (ie, a
dividend payout ratio of 50%). The analyst expects the company to gradually increase the ratio to 65% over
the next 3 years (ie, to 55% in 20X3, 60% in 20X4, and 65% in 20X5 and 20X6).
Exhibit 10 Consolidated historical and projected statement of cash flows for Dettifoss
20X1 20X2 20X3E 20X4E 20X5E 20X6E

(ISK millions)
Net income 209 228 289 360 418 532
Depreciation and amortization 89 85 86 87 89 91
Share-based compensation 0 0 0 0 0 0
Investment in working capital (2) (15) (19) (22) (24) (26)
CF from operating activities 296 298 356 425 482 597
CAPEX (80) (93) (106) (120) (135) (149)

CF from investing activities (80) (93) (106) (120) (135) (149)
Debt issuance (net) 154 269 0 0 0 0

Share issuance (net) 1 (0) 0 0 0 0
Dividends paid (105) (114) (159) (216) (271) (346)
CF from financing activities 50 155 (159) (216) (271) (346)
Net change in cash 266 360 91 88 76 102
Beginning cash position 150 416 776 867 955 1,031

Ending cash position 416 776 867 955 1,031 1,132
Forecasted Balance Sheet

The forecasted balance sheet in Exhibit 11 is based on the combination of forecasts from the statement of
cash flows and the income statement. For each year, common equity is calculated as the sum of the ending
balance of the previous year and net income, net of dividends paid.
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Exhibit 11 Consolidated historical and projected balance sheet for Dettifoss
20X0 20X1 20X2 20X3E 20X4E 20X5E 20X6E

(ISK millions)
Cash and equivalents 150 416 776 867 955 1,031 1,132
Accounts receivable 85 89 102 121 142 166 191
Inventories 40 48 49 55 64 74 82
Total current assets 275 553 927 1,042 1,161 1,270 1,406
PPE 1,720 1,711 1,719 1,739 1,773 1,819 1,877

Investments 0 0 0 0 0 0 0
Total assets 1,995 2,264 2,645 2,781 2,933 3,088 3,282
Short-term debt 120 150 170 140 140 140 140

Accounts payable 36 46 45 50 59 67 75
Total current liabilities 156 196 215 190 199 207 215
Long-term debt 1,457 1,581 1,830 1,860 1,860 1,860 1,860

Total common equity 382 487 600 731 875 1,021 1,207
Total liabilities and equity 1,995 2,264 2,645 2,781 2,933 3,088 3,282
Valuation Model Inputs

The financial statements projected in the previous sections are usually a good starting point for discounted
cash flow models. Exhibit 12 shows the inputs for a common valuation model based on free cash flow to the
firm (FCFF). FCFF is calculated as the after-tax EBIT [ie, EBIT × (1 − Tax rate)], adding back depreciation
and amortization, and net of changes in working and fixed capital.
Exhibit 12 Free cash flow to the firm for Dettifoss
20X3E 20X4E 20X5E 20X6E

(ISK millions)
EBIT 414 502 574 717
Taxes (EBIT × 20%) (83) (100) (115) (143)
After-tax EBIT 331 401 459 574

Depreciation and amortization 86 87 89 91
Change in working capital (19) (22) (24) (26)
CAPEX (106) (120) (135) (149)
Free cash flow to the firm 291 346 389 489
Vol 2-135
Learning Module 7
Behavioral Finance and Analyst Forecasts
LOS: Explain how behavioral factors affect analyst forecasts and recommended remedial
actions for analyst biases.
Experts in many fields make forecasting errors that arise from behavioral biases. In order to improve
forecasts and the investment decisions based on them, analysts should be aware of the impact of biases
and ways they can potentially be reduced. The five key behavioral biases are:
y Overconfidence
y Illusion of control
y Conservatism
y Representativeness
y Confirmation
Overconfidence in Forecasting
People tend to have unwarranted faith in their own abilities, especially when making contrarian predictions.
In order to mitigate this bias, analysts should record and review each forecast they make, which enables
them to identify its eventual accuracy. Analysts who determine that their forecast error rates are high can
take mitigating actions such as widening confidence intervals and conducting scenario analysis with factors
included that would make a forecast incorrect.
Illusion of Control
This bias involves overestimating one’s ability to control factors that likely cannot be controlled and taking
fruitless actions in pursuit of that control. Illusion of control is closely linked to overconfidence. Analysts can
improve forecasting accuracy by creating more complex and granular models that incorporate more data
and expert opinions, but their efforts may reach a point of diminishing, marginal improvements if some of
the information is immaterial, and excessive breadth and complexity can conceal the analyst’s assumptions.
In addition, the investment of time and resources to create complex models leads to opportunity costs.
Illusion of control can be mitigated by restricting modeling variables to those that are regularly disclosed
by the company, focusing on the most important or impactful variables, and using information only from
professional sources likely to have unique or significant perspectives.
Conservatism Bias
Conservatism bias refers to bias in which people maintain their prior forecasts instead of incorporating
additional information that may change their view. Although the most common form of conservatism bias
is a reluctance to incorporate new, negative information, analysts might also fail to adequately incorporate
positive information. Conservatism bias has also been described as “anchoring and adjustment,” in which
the analyst takes an old forecast and updates it. While there is nothing wrong with adjusting previous
forecasts, the adjustments are often too small, resulting in a new forecast too close to the previous one.
This bias can be mitigated by having an investment team review forecasts and models at regular intervals
and by creating flexible models with fewer variables. The mitigation of overconfidence and illusion of control
will also help mitigate conservatism.
Vol 2-136
Representativeness Bias
Representativeness bias refers to the tendency to classify information based on past experiences and
known classifications. New information that resembles previously classified elements may in fact be quite
different or have different implications. Base rate neglect is a common form of representativeness that
occurs when the rate of incidence of one phenomenon is ignored in favor of more familiar situations or
information.
Often, the best approach is to begin with the base rate but also determine which factors make the target
company different from the base rate and the implications of those differences.
Confirmation Bias
Confirmation bias is a tendency to look for and notice evidence that confirms prior beliefs while ignoring
or undervaluing evidence that contradicts those beliefs. For example, an analyst might research a
particular company but ignore or undertake only cursory research on competitors and companies that offer
substitute products.
It is valuable to speak with management, given the importance of their role, but analysts should be aware
of management’s inherent bias and seek different, additional perspectives. Confirmation bias can also be
mitigated by seeking differing opinions from other analysts, as well as the perspectives of colleagues who
are not economically or psychologically invested in the company.
The Impact of Competitive Factors on Prices and Costs
LOS: Explain how competitive factors affect prices and costs.
LOS: Evaluate the competitive position of a company based on Porter’s five forces.
Porter’s Five Forces

Characteristics of Porter’s five forces are shown in Exhibit 13:
Exhibit 13 Characteristics of Porter's five forces
Force Descriptions Factors
y Economies of scale
y Brand loyalty
Increased competition can lower
Threat of new entrants profits, out profits, but barriers to y Switching costs
entry can protect them
y Fixed costs
y Regulation
y Ease of product substitution

Bargaining power Increased input costs lower profit
y Concentration of suppliers
of suppliers margins
y Switching costs
Vol 2-137
Learning Module 7
Force Descriptions Factors
y Customer concentration
Bargaining power of
Limited prices lower profit margins y Switching costs
buyers (customers)
y Vertical integration
Increased competition can lower y Similarities in function

Threat of substitutes
sales quantities and/or prices y Utility of substitutable products
y Industry fragmentation
Rivalry among Increased competition lowers
y Degree of product differentiation
existing competitors prices and profit margins
y Barriers to exit
Exhibit 14 presents the analyst’s conclusions after assessing Dettifoss Industries and the alcoholic
beverage industry using Porter’s framework.
Exhibit 14 Competitive analysis of Dettifoss Industries
Force Degree Factors to consider
Customers are not inclined to replace mead with substitutes

Threat of substitutes Very low (eg, beer, wine). Also, customers are very loyal to Dettifoss’s
brands, such as Askja and Hekla.
Although there are other mead producers in the Nordic

Rivalry among
Very low countries, Dettifoss is the largest by far and the only one that
existing competitors
operates in the United Kingdom, a very relevant market.
Although there are many suppliers of ingredients (eg, honey,

Bargaining power
Medium yeast), Dettifoss relies on a few sizable suppliers of cans and
of suppliers
bottles, who also sell to large beer companies.
Most of the mead products are sold to small, specialized liquor

Bargaining power
Low stores and upscale restaurants, not large chains. The smaller
of buyers
buyers are not organized to coordinate purchases.
The machinery needed is not expensive, and high margins

could attract new competitors. However, Dettifoss’s long-term
Threat of new entrants Low
relationships and contracts with buyers are a high barrier
to entry.
Based on this framework, the analyst concludes that Dettifoss Industries has a strong position in its market
and should be able to benefit from increasing demand for mead products. In the model (see the Revenue
Forecast section), the analyst has assumed that volume growth will remain strong and that Dettifoss will
improve its price/mix, especially in 20X3.
Vol 2-138
According to the COGS section, the analyst believes costs will continue to decrease during the forecast
period; however, Porter’s framework suggests that the analyst should also pay attention to the risk of cost
increases due to pressure from large suppliers of containers (ie, cans, bottles).
There are other factors, such as government involvement (ie, regulation), that should also be considered,
not as additional forces but as something that can impact Porter’s five forces.
Inflation and Deflation
LOS: Explain how to forecast industry and company sales and costs when they are subject to
price inflation and deflation.
Sales Projections with Inflation and Deflation
Industry Sales and Inflation/Deflation

Most increases in the cost of inputs (eg, commodities, labor) will eventually result in higher prices for end
products. Industry structure can be an important factor when determining the relationship between higher
input costs and increases in the price of end products. For example, if an industry sells primarily to clients
with limited bargaining power, cost increases are more likely to be passed along to customers in the form of
higher prices.
Company Sales and Inflation/Deflation

The ability of a company to pass prices along to customers depends not only on the price elasticity of
demand of the company’s product but also on the reactions of competitors.
In an inflationary environment, raising prices too late will result in a lower profit margin, and raising prices
too soon will cause a decline in volume. In contrast, in a deflationary environment, lowering prices too soon
will result in a lower gross margin, while waiting too long to do so will cause a decline in volume.
For an international company, the expected pricing component should also consider the geographic mix of
the company’s revenues and the different rates of inflation among the countries—without omitting strategy
and the competitive factors in each market. In addition, a country’s currency will generally come under
pressure and depreciate if high rates of inflation persist for an extended period.
Analysts should identify a company’s major input costs, which provide an indication of likely pricing.
The company’s strategy can also provide valuable insights. Some companies prioritize market share over
margins, while others prefer to maintain high margins.
Vol 2-139
Learning Module 7
Industry Costs and Inflation/Deflation

Familiarity with the specific purchasing characteristics of an industry can be useful when forecasting costs.
For instance, if an industry has long-term fixed-price contracts, or participants typically hedge their costs,
then the impact of price increases could be delayed. It can also be helpful to monitor the underlying drivers
of input prices since, for example, the prices of agricultural products depend on weather conditions.
How inflation or deflation affects an industry’s cost structure depends on the competitive environment. If the
industry is vertically integrated or if the participants have access to alternative inputs, the impact of price
volatility won’t be as severe.
Company Costs and Inflation/Deflation

When forecasting a company’s costs, it is often helpful to segment the cost structure by category
and geography.
Technological Developments
LOS: Evaluate the effects of technological developments on demand, selling prices, costs,
and margins.
Technological developments have the potential to change the economics of individual businesses and
entire industries. Sensitivity analysis is useful for considering the range of possible outcomes. When a
technological development results in a new product that threatens to cannibalize demand for an existing
product, an expected cannibalization factor can be used to estimate the impact on future demand.
New technology can affect not only the demand for a product, but also the quantity supplied. When changes
in technology reduce manufacturing costs, the supply curve will shift to the right, and suppliers will be willing
to produce higher volume at the same price. On the other hand, advanced technology can cause the supply
curve to shift to the left if it leads to the development of an attractive substitute product.
When the effects being estimated are dependent on many different variables that are difficult to measure,
a range of estimates based on various scenarios will be needed. To do this, a base case scenario should
first be generated; then the sensitivity of results can be analyzed by altering a few assumptions for each
subsequent scenario.
Long-Term Forecasting
LOS: Explain considerations in the choice of an explicit forecast horizon.
LOS: Explain an analyst’s choices in developing projections beyond the short-term

forecast horizon.
The choice of the forecast time horizon can be influenced by factors such as investment strategy and the
preferences of the analyst’s employer. The time frame should ideally correspond to the average annual
turnover of the portfolio. If the stated investment horizon is between 3 and 5 years, then the average
turnover would be between 20% and 33%; the average holding period equals 1 / Portfolio turnover. The
Vol 2-140
cyclicality of the industry could also influence the analyst’s choice of time frame since the forecast period
should be long enough to allow the business to reach an expected mid-cycle level of sales and profitability.
Longer-term projections often provide a better representation of the normalized earnings potential of a
company than the short-term forecast. Normalized earnings is the expected level of mid-cycle earnings for
a company in the absence of any unusual or temporary factors (eg, mergers and acquisitions, restructuring)
that affect profitability. Normalized free cash flow is the expected level of mid-cycle cash flow from
operations, adjusted for unusual items. By extending the forecast period, the analyst is better able to adjust
for such factors.
As with income statement projections, a long-term forecast begins with a revenue projection, and most of
the remaining income statement items are derived from the level or change in revenues.
An analyst creating a valuation model, such as the discounted cash flow (DCF) model, must estimate a
terminal value in order to capture the company’s going-concern value after the explicit forecast period. The
analyst should consider whether the terminal year free cash flow should be normalized before incorporation
into a long-term projection or adjusted for an abnormal period in the business cycle. The analyst should also
consider whether the long-term growth rate will differ from the historical growth rate.
One of the biggest challenges facing the analyst is anticipating inflection points when the future could be
significantly different from the past. Most DCF models rely on a perpetuity calculation, which assumes that
the cash flows from the last year of a forecast grow at a constant rate forever. It is critical that the last year’s
cash flows represent normalized or mid-cycle results.
The economy can occasionally experience sudden, unprecedented changes (eg, the 2008 global financial
crisis, the COVID-19 pandemic) that affect a wide variety of companies. Regulation and technology are also
potential drivers of inflection points, and it is important for analysts to monitor both.
Long-term growth is a key input in the perpetuity calculation. Some companies and industries can grow
faster than the overall economy for long periods of time, which means they account for an increasing
share of overall output. The technology sector has several examples of such high growth companies. In
contrast, companies in the print media sector are likely to grow more slowly than the overall economy or
even to shrink. Using an unrealistic long-term growth assumption can severely damage the accuracy of a
valuation model.
Vol 2-141
Learning Module 7
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Financial

Basic Corporate Investment Categories

Investments in marketable debt and equity securities can be categorized as:

Exhibit 1 Summary of accounting treatment for investments

Influence Not significant Significant Controlling Shared control

Investments in Financial Assets: IFRS 9

Classiﬁcation and Measurement

Type of security Debt Equity

Classification Amortized cost Fair value Fair value

Investments in Associates and Joint Ventures

y Representation on the board of directors

Equity Method of Accounting: Basic Principles

Example 1 Equity method

Income ($) Dividends ($)

20X6 350,000 100,000

Initial cost $500,000

Equity income for 20X6: 20% of 350,000 = $70,000

Amortization of Excess Purchase Price, Fair Value Option,

Amortization of Excess Purchase Price

Example 2 Equity method investments with goodwill

Book value ($) Fair value ($)

Current assets 220,000 220,000

1. Goodwill included in the purchase price

1. Purchase price $700,000

2. Proportionate share in Alton’s 20X7 earnings ( = 25% × $250,000) $62,500

3. Purchase price $700,000

Fair Value Option

Transactions with Associates and Disclosure

Example 3 Equity method for transactions with associates

Unrealized proﬁt = $12,000

Prime’s proﬁt on sale to Alton = 160,000 − 100,000 = $60,000

Revised equity income for 20X9 = 57,500 − 3,000 − 1,875 = $52,625

Issues for Analysts

Exhibit 3 Classiﬁcation of business combinations: US GAAP

y Parent and subsidiary continue to operate as separate entities

y Parent must acquire 100% of subsidiary

y Parent must acquire 100% of subsidiary

Recognition and Measurement of Identiﬁable Assets and Liabilities

Recognition and Measurement of Contingent Liabilities

Recognition and Measurement of Indemniﬁcation Assets

Recognition and Measurement of Financial Assets and Liabilities

Recognition and Measurement of Goodwill

Example 4 Acquisition method

Pyramid Inc. Sam Corp.

Book value Book value Fair value

Cash and receivables 12,500 450 450

Excess purchase price = Cost of acquisition − BV of net assets acquired

($10 × 1,000,000) − $1,450,000 = $ 8,550,000

Excess purchase price $8,550,000

Consolidated Balance Sheet ($ thousands)

Cash and receivables (= 12,500 + 450) 12,950

Capital stock = Parent’s capital stock + Par value of shares issued

= $5,500,000 + $1,000,000 = $6,500,000

= $7,000,000 + [(1,000,000 × 10) − (1,000,000 × 1)] = $16,000,000

The Consolidation Process

Business Combinations with Less Than 100% Acquisition

Noncontrolling (Minority) Interests: Balance Sheet

Noncontrolling (Minority) Interests: Income Statement

Example 5 Goodwill and noncontrolling interests