Welcome to the belly of the financial reporting beast.  Candidates are expected to understand accounting for: intercorporate investments, retirement (or post-employment) benefits, stock (or share) based compensation, and multi-national operations.  Compared to the other sections this is one of the longest sections.  The good news is that the math is not particularly complicated, but there are a number of decision rules and procedural steps to learn.  This series is designed to provide a framework of understanding for the aforementioned financial accounting issues.  However, to be fully prepared for the exam, candidates will need to repeatedly work through examples with this framework in order to be fully prepared for item sets on the exam.  It is reasonable to expect that each of these items will be touched upon in the exam.

<strong>Definitions</strong>

<strong>Fair Value:</strong> Commonly synonymous for an asset’s market value, however some assets do not have a readily observable market price, which increases the subjectivity in determining the asset’s fair value.

<strong>Financial Statements:</strong> Refers to a company’s: income statement, balance sheet, statement of cash flows, and/or statement of changes in owner’s equity.  There will be several references to the statement of changes in owner’s equity in this section.

<strong>Material:</strong>

This series will discuss the following material:

I.          Intercorporate Investments Accounting

II.        Retirement (Post-employment) Compensation and Benefits Accounting

III.       Stock (Share) Based Compensation Accounting

IV.       Financial Statement Consolidation of Multinational Operations

CFA Level 2: Financial Reporting Part 2 – Introduction

Companies commonly make equity or debt investments in other companies.  Ownership can be minority (less than 50%) or majority (greater than 50%) and the degree of operational influence can be passive or active.  Naturally, these differences lead to differences in accounting treatments for which the well-trained financial analyst must be prepared to interpret.

The following table shows the categories of ownership recognized by U.S. GAAP and IFRS for the purposes of public financial reporting.
<table class="mytable" style="margin-top: 15px;">
<tbody>
<tr>
<th scope="col">INVESTMENT CATEGORY</th>
<th scope="col">LEVEL OF INVESTOR INFLUENCE</th>
<th scope="col">INVESTOR OWNERSHIP LEVEL</th>
<th scope="col">ACCOUNTING METHOD</th>
</tr>
<tr>
<td>Minority Passive</td>
<td>Not material.</td>
<td>Less than 20%</td>
<td>Four classes of accounting treatment:

1) held to maturity (HTM)
2) available for sale (AFS)
3) held for trading (HFT)
4) designated fair value instruments</td>
</tr>
<tr>
<td class="alt">Minority Active</td>
<td class="alt">Significant.</td>
<td class="alt">20% - 50%</td>
<td class="alt">Equity Method</td>
</tr>
<tr>
<td>Joint Venture</td>
<td>Joint control.</td>
<td>Joint venture</td>
<td><strong>US:</strong> Equity Method
<strong>IFRS:</strong> Equity Method (proportionate consolidation previously allowed)</td>
</tr>
<tr>
<td class="alt">Controlling Interest</td>
<td class="alt">Control.</td>
<td class="alt">More than 50%</td>
<td class="alt">Consolidation</td>
</tr>
</tbody>
</table>
 

Intercorporate Investments Accounting - Ownership Categories

<strong>1. Held-to-Maturity (HTM) securities (or debt investments) </strong>

An HTM security is a debt investment made by an investor company that is intended to be and able to be held until it matures.  HTM securities are typically reported under long-term assets on the balance sheet.  The investor company carries HTM investments at amortized cost.

<strong>2. Available for Sale (AFS) securities  </strong>

AFS securities include equity securities that an investor company does not intend to trade in the short term and debt securities that the investor company does not into to trade short term and not classified as HTM.
<ol>
	<li>AFS securities can be reported on the balance sheet as current assets or long-term assets.</li>
	<li>AFS securities are reported at fair value.</li>
	<li>Income Statement: Dividend income, interest income, realized gains and realized losses from AFS securities are reported on the investor company’s income statement.</li>
	<li>Unrealized Gains and Losses from AFS Securities:</li>
</ol>
<table class="mytable" style="margin-top: 15px;">
<tbody>
<tr>
<th style="text-align: center; width: 50%;" scope="col">GAAP</th>
<th style="text-align: center;" scope="col">IFRS</th>
</tr>
<tr>
<td>Appreciation in market value of AFS securities are not reported on the income statement and do not impact net income. AFS market value changes are reflected on the balance sheet; the difference between net income and the equity value on the balance sheet is reconciled by the firm's other comprehensive income (OCI) activities. Once the AFS securities are sold, the accumulated OCI adjustments to the balance sheet are reversed and a gain or loss is finally recognized on the company's income statement.</td>
<td>Applies a designation called "net income recognized directly in equity" which is similar to OCI in GAAP.</td>
</tr>
</tbody>
</table>
<strong>3. Held for Trading (HFT) securities</strong>
<ol>
	<li>Debt or equity securities that an investor company intends to trade, commonly within the next quarter.</li>
	<li><strong>Balance Sheet:</strong> HFT securities are typically current assets and reported at fair value.</li>
	<li><strong>Income Statement:</strong> under both IFRS and GAAP, dividend income, interest income, realized gains and losses, and unrealized gains and losses are reported on the income statement.</li>
	<li><strong>Example:</strong> Thinking about the nature of HFT securities, many companies are not likely to frequently report HFT assets on the balance sheet.  A company likely to regularly report HFT securities on its balance sheet would be a financial services firm, as a standard business activity for an entity like an investment bank could involve trading securities.</li>
</ol>
<strong>4. Designated Fair Value Instruments</strong><strong> </strong>

As of 2009, both IFRS and GAAP allowed companies to designate financial assets as fair value instruments.  Once this classification is made, it cannot be changed and the reporting is similar to that of HFT securities, as unrealized gains and losses are reported directly on the income statement and not as part of other comprehensive income or net income recognized directly in equity.

Minority Passive Investments – Accounting Classes

A minority investor company can hold material influence over the investee company and this commonly occurs at the 20% to 50% voting rights ownership level.

<span style="text-decoration: underline;">Significant Influence Indicators</span>: Example indicators of significant influence are: investor seats on the board of the investee, sharing of management by investor and investee, or a shared technology dependency between investor and investee.

<strong>Equity Method</strong> for Minority Active Investment Reporting on Investor Company Balance Sheet (GAAP &amp; IFRS).
<ul>
	<li>GAAP and IFRS require that companies apply the equity method of accounting to report for minority active investments (i.e. less than 50% ownership, but significant investor influence over investee).</li>
</ul>
<img class="aligncenter size-full wp-image-5836" title="bs math" src="https://financetrain.com/wp-content/uploads/bsmath.gif" alt="" />
<ul>
	<li>Note: the Share of the Investee’s Net Income may be adjusted due to goodwill carried on the investor’s balance sheet resulting from an acquisition price greater than its book value.</li>
</ul>
<h3 class="hdpline"><span>Equity Method Important Points</span></h3>
<ul>
	<li><strong>Fair Value &amp; the Equity Method:</strong> A change (reduction) to the fair value of the equity investment on the minority active investor’s balance sheet is not recognized unless there is a permanent impairment in value.</li>
	<li><strong>Analyst Thinking &amp; the Equity Method:</strong> If there is a material divergence between the fair value reported on the equity investor company’s balance and the current market value of the equity investment, then a financial analyst would look to adjust the investor company’s financials to reflect the market value.</li>
	<li><strong>Net Income, Cash Flows, &amp; the Equity Method:</strong> Net Income from the investee company is non-cash income for the investor company and therefore does not impact the investor company’s cash flows.</li>
	<li><strong>Dividends &amp; the Equity Method:</strong> Dividends received by the minority active investor from an equity investee are part of the investor’s operating cash flow. <span style="text-decoration: underline;">Dividend from Equity Investee</span> = reported income from equity investee on the investor’s income statement minus the change in the investment in investee on the investor’s balance sheet.</li>
	<li>Equity Investment Changes over Time: The equity method, in effect, treats investee net income as reinvested earnings, which increases or decreases (in the event of losses) the value of the equity investment reported on the investor’s balance sheet over time.</li>
</ul>
<h3 class="hdpline"><span>Equity Method Issues</span></h3>
<strong>Investment Cost in Excess of the Investee’s Book Value</strong>
<div class="formula1">

BV of Investee = BV of Total Assets – BV of Total Liabilities</div>

Commonly when a company makes a minority active investment, the price paid exceeds the proportional book value of its stake in the investee.  For example, an investor company may pay 60% of the book value to acquire a 50% stake in another company.

The equity method has a <strong>two-step</strong> approach for reconciling the difference between the book value of the equity investment and the cost of the investment, where book value = bv of assets – bv of liabilities.

<img class="aligncenter size-full wp-image-5833" title="Equity Method Steps" src="https://financetrain.com/wp-content/uploads/equity-steps.gif" alt="" />

&nbsp;

<strong>Impairment and the Equity Method</strong>

A minority active investor company’s equity investments must be tested for impairment.

<strong>Example:</strong> Assume that a large pharmaceutical company has made an investment in a small laboratory.  The laboratory is focused on the development of a single drug.  In the event that this drug fails its approval tests by government regulators shortly after the investor company reports its financial statements to the public, then the balance sheet value of the large pharmaceutical company’s stake in the small lab is likely to have declined.

<strong>Impairment:</strong> When the fair value of the equity investment falls permanently below its carrying value on the investor’s balance sheet, then an impairment loss must be recognized on the investor’s income statement and the value of the investment on the balance sheet is reduced to its fair value.

<strong>US GAAP &amp; Impairment:</strong> reversal of impairment losses is not allowed.

<strong>IFRS &amp; Impairment:</strong> reversal of impairment losses is allowed.

</div>

Minority Active Investments and the Equity Method for Financial Reporting

Sometimes a small group of investors will own and operate a business entity; this entity is a joint venture.

<span style="text-decoration: underline;">US GAAP &amp; Joint Ventures</span>:  most often, the equity method of accounting is required.

<span style="text-decoration: underline;">IFRS &amp; Joint Ventures</span>: prior to early 2009 both the proportionate consolidation and equity accounting methods were allowed for joint ventures under IFRS.  This was changed and now only the equity method is permitted for companies that must report joint venture business activities.

Joint Venture Investments

Control of a subsidiary typically occurs when the parent/investor company owns more the 50% of the investee’s voting stock.  However, an investor company can retain control with less than 50% voting ownership.

IFRS and GAAP require that the financial statements of a controlling investor company and its controlled subsidiaries be consolidated.

<strong>Business Combination Types (4)</strong>
<ol>
	<li><span style="text-decoration: underline;">Statutory Merger</span> – two companies combine, but only one entity survives; the investor may pay cash, issue stock, or issue debt to finance its investment.</li>
	<li><span style="text-decoration: underline;">Statutory Consolidation</span> – two companies combine, but both cease to exist and a new company is formed.</li>
	<li><span style="text-decoration: underline;">Acquisition</span> – the two companies remain legally distinct entities, but are associated through a parent company-subsidiary relationship.  In situations where the parent owns less than 100% of the subsidiary, then minority interest will be reported on the parent company’s financial statements.</li>
	<li><span style="text-decoration: underline;">Variable Interest Entities (VIEs)</span> – also called Special Purpose Entities (SPEs), VIEs are consolidated when the parent company, serving as the VIE’s sponsor, is the primary beneficiary of the VIE’s activities.</li>
</ol>
<strong>Methods of Accounting for Business Combinations (3)</strong>

<strong>Purchase Method:</strong> Under the purchase method, the assets and liabilities of the acquired company are combined onto the financial statements of the acquiring company at fair market values on the transaction date.

<strong>Pooling of Interests Method:</strong> Under the pooling method, the assets and liabilities of the parent and subsidiary are simply combined. The method simply adds the asset and liability book values appearing on the parent’s and subsidiary’s balance sheet. This method was disallowed by GAAP in 2001 and disallowed by IFRS in 2004.

<strong>Acquisition Method: </strong>U.S. GAAP requires the acquisition method when accounting for controlling interest business combinations, starting in December 2008. The acquired identifiable assets and liabilities are recognized at full fair value, even if the parent purchases less than 100% of the subsidiary.

Controlling Interest Investments: Accounting for Business Combinations

Under the purchase method, the assets and liabilities of the acquired company are combined onto the financial statements of the acquiring company at fair market values on the transaction date.

<img class="aligncenter size-full wp-image-5833" title="Purchase Method" src="https://financetrain.com/wp-content/uploads/purchase_method.gif" alt="" />

Steps in the purchase method (note that the process starts with the balance sheet and ends with the income statement):

NOTE: The process of creating a consolidated balance sheet and income statement through the purchase method is time consuming and requires practice.  Candidates are advised to begin by practicing problems with notes and books available and gradually building proficiency to the point of successfully completing the process without assistance.

Purchase Method of Accounting for Controlling Interest Investments or Acquisitions 

Under the pooling method, the assets and liabilities of the parent and subsidiary are simply combined.

Unlike the <a title="Purchase Method of Accounting for Controlling Interest Investments or Acquisitions" href="https://financetrain.com/purchase-method-of-accounting-for-controlling-interest-investments-or-acquisitions/">purchase method</a>, the assets and liabilities of the acquired company are not restated to fair value, but maintained at book value.  The method simply adds the asset and liability book values appearing on the parent’s and subsidiary’s balance sheet.

No goodwill is created under the pooling method on the consolidated balance sheet.

Operating results from the income statement are combined retroactively.

IFRS and GAAP have <strong><em>disallowed</em></strong> the pooling (or uniting) of interests accounting method.

Pooling of Interests Method to Account for Controlling Interest Investments

The following table illustrates some of the consolidated financial statement differences between the <a title="Purchase Method of Accounting for Controlling Interest Investments or Acquisitions" href="https://financetrain.com/purchase-method-of-accounting-for-controlling-interest-investments-or-acquisitions/">purchase method</a> and <a title="Pooling of Interests Method to Account for Controlling Interest Investments" href="https://financetrain.com/pooling-of-interests-method-to-account-for-controlling-interest-investments/">pooling of interest method</a>.
<table class="mytable">
<tbody>
<tr>
<th scope="col">Item</th>
<th scope="col">PURCHASE METHOD</th>
<th scope="col">POOLING OF INTERESTS METHOD</th>
</tr>
<tr>
<th class="spec" scope="row">Book Value</th>
<td>Typically higher than pooling method.</td>
<td>Typically lower than purchase method, as no goodwill asset is created.</td>
</tr>
<tr>
<th class="specalt" scope="row">Earnings Trend</th>
<td class="alt">Typically lower than the pooling method because pre-acquisition income statements are not combined.</td>
<td class="alt">Typically higher than purchase method because income statements are combined retroactively.</td>
</tr>
<tr>
<th class="spec" scope="row">Sales Trend</th>
<td>Typically distorts growth perception of the acquiring company, as much of its sales growth can be attributed to the acquisition.</td>
<td>Typically more accurate than the purchase method, as income statements are combined retroactively.</td>
</tr>
<tr>
<th class="specalt" scope="row">Earnings Per Share</th>
<td class="alt">Typically lower than the pooling method.</td>
<td class="alt">Typically higher than the purchase method, as the income statement is combined for the entire reporting period, rather than as of the acquisition date.</td>
</tr>
<tr>
<th class="spec" scope="row">ROA &amp; ROE</th>
<td>Typically lower.</td>
<td>Typically higher.</td>
</tr>
</tbody>
</table>
 

Purchase Method vs. Pooling of Interest Method

U.S. GAAP requires the acquisition method when accounting for controlling interest business combinations, starting in December 2008.

Under the Acquisition Method:
<ul>
	<li>The acquired identifiable assets and liabilities are recognized at full fair value, even if the parent purchases less than 100% of the subsidiary.</li>
</ul>
<ul>
	<li>Direct costs in support of the acquisition (ex. legal fees) are not added to the acquisition price, but are directly expensed by the acquirer.</li>
</ul>
<ul>
	<li>Contingent assets and liabilities are recognized at their fair value on the transaction date.</li>
</ul>
<ul>
	<li>In process research and development (R&amp;D) is recognized at fair value as an intangible asset.  This asset is not amortized, but tested annually for impairment.</li>
</ul>
<ul>
	<li>The fair value of the subsidiary on the transaction date is used to calculate minority interest.</li>
</ul>
<ul>
	<li>Minority interest is reported under the equity section of the consolidated balance sheet (recall that under the purchase method, U.S. GAAP placed minority interest on the mezzanine between debt and equity).</li>
</ul>

Acquisition Method to Account for Controlling Interest Investments

The table below summarizes some differences between <a title="Purchase Method of Accounting for Controlling Interest Investments or Acquisitions" href="https://financetrain.com/purchase-method-of-accounting-for-controlling-interest-investments-or-acquisitions/">GAAP Purchase Method, IFRS Purchase Method</a>, and <a title="Acquisition Method to Account for Controlling Interest Investments" href="https://financetrain.com/acquisition-method-to-account-for-controlling-interest-investments/">GAAP Acquisition Method</a> accounting.
<table class="mytable">
<tbody>
<tr>
<th scope="col">Item</th>
<th scope="col">PURCHASE METHOD: GAAP</th>
<th scope="col">PURCHASE METHOD: IFRS</th>
<th scope="col">ACQUISITION METHOD: GAAP</th>
</tr>
<tr>
<th class="spec" scope="row">Purchase Price</th>
<td>Cash Paid + fair value of other considerations + direct costs</td>
<td>Same as GAAP Purchase Method.</td>
<td>Cash Paid + fair value of other considerations.</td>
</tr>
<tr>
<th class="specalt" scope="row">Fair Value of Subsidiary</th>
<td class="alt">When parent acquires less than 100%, the amount of fair value over book value is recognized in proportion to the parent's ownership.</td>
<td class="alt">Consolidated balance sheet recognizes the full amount of the fair value in excess of the acquired company's book value (note this difference from GAAP).</td>
<td class="alt">Same as IFRS Purchase Method.</td>
</tr>
<tr>
<th class="spec" scope="row">Subsidiary Contingent Liabilities</th>
<td>Recognized on the sale date at fair value.</td>
<td>Same as GAAP Purchase Method.</td>
<td>Same as GAAP Purchase Method.</td>
</tr>
<tr>
<th class="specalt" scope="row">Subsidiary In-Process R&amp;D</th>
<td class="alt">Recognized on the sale date at fair value, as part of the subsidiary's net assets, then expensed.</td>
<td class="alt">Recognized on the sale date at fair value as part of the subsidiary's net assets; reported on the consolidated balance sheet as an intangible asset.</td>
<td class="alt">Same as IFRS Purchase Method.</td>
</tr>
<tr>
<th class="spec" scope="row">Minority Interest</th>
<td>Based on subsidiary's book value of net assets owned by minority shareholders.



Appears between debt and equity on the consolidated balance sheet.</td>
<td>Either:


1) Subsidiary's fair value of net assets owned by minority shareholders, which creates partial goodwill.



2) Subsidiary's full fair value, applied to percent ownership by minority shareholders, which creates full goodwill.Appears under equity section on the consolidated balance sheet.</td>
<td>Subsidiary's full fair value, applied to percent ownership by minority shareholders, which creates full goodwill.



Appears under equity section on the consolidated balance sheet.</td>
</tr>
</tbody>
</table>
NOTE: This table helps to highlight how the Acquisition Method in the US is more aligned with the IFRS Purchase Method.

 

GAAP Purchase Method, IFRS Purchase Method, and GAAP Acquisition Method Accounting

<ul>
	<li>A company may elect to create (or sponsor) a VIE or SPE as a separate business entity, in order to isolate assets and liabilities for structured finance purposes.</li>
	<li><strong>Example:</strong> a company may create an SPE for the sole purposes of securitizing the receivables of the primary business unit.</li>
	<li>Following a wave of accounting scandals in the early 2000s, U.S. accounting rules were changed to require that the financial statements of VIEs be consolidated on the sponsoring company’s financial statements when the sponsor is in position to incur most of the VIE’s losses or retain most of the VIE’s returns.  The sponsor is the primary beneficiary of the VIE.</li>
	<li>It is common for VIEs/SPEs to hold financial assets, loans, trade receivables, real estate, and/or other property.</li>
	<li>One potential benefit of creating a VIE is that it can lower the sponsor’s financing costs for a specific business venture.</li>
	<li>A sponsor’s control over VIE cannot necessary be measured by voting stock.  The interest is variable because the VIE will incur a portion of the losses or retain a portion of the gains.</li>
	<li>Examples of variable interests include: sponsor guarantee’s on VIE assets, credit enhancements, or lease arrangements.</li>
	<li>If one of the following conditions is met, then an entity qualifies as a VIE and its financial statements must be consolidated with the sponsor’s financial statements.</li>
<ol>
	<li>If the total equity investment in the entity at risk is not large enough to absorb its potential losses, then the entity is a VIE.  The standard level is 10%, that is, if the equity investment at risk is less than 10% of the entity’s assets, then the entity is a VIE.</li>
	<li>If the equity investors in the entity do not possess any one of the following characteristics of a controlling financial interest:</li>
<ul>
	<li>Investors cannot control the entity’s affairs through share voting.</li>
	<li>Investors are not responsible to absorb losses from the entity, if they occur.</li>
	<li>Expected entity returns are capped for equity investors.</li>
</ul>
</ol>
	<li>If one of the conditions is met, then the entity qualifies as a VIE and must be consolidated onto the sponsoring company’s financial statements.  The consolidating company is called the primary beneficiary of the VIE.</li>
	<li>The primary beneficiary may own no voting shares in the VIE, but it retains control over the VIE through other means.  The equity investors in the VIE commonly exchange their right to greater returns for a guaranteed rate of return.</li>
	<li>Under U.S. GAAP, certain SPEs may qualify for exemption of the consolidation requirement if certain conditions are met.  These are called qualifying SPEs (QSPEs).  QSPEs are not permitted under IFRS.</li>
</ul>
 

Variable Interest Entities (VIEs) and Special Purpose Entities (SPEs)

Company provision of employee retirement (or post-employment) benefits often takes one of two forms:
<ul>
	<li>Defined contribution (DC) plans</li>
	<li>Defined benefits (DB) plans</li>
</ul>
<strong>Defined Contribution (DC) Plans</strong>

DC plans outline the periodic amounts than a retirement plan sponsor (the employing company) contributes to the retirement plan and how those contributions are provided to employees.
<ul>
	<li><strong>DC Plan Example:</strong> In the U.S., a common form of DC plan is the 401(k) plan, where the employer will contribute a percentage of the employee’s salary to the plan or will match contributions made by the employee.  Each individual employee will have a personal account under the employer’s 401(k) and the employer must provide a range of investments, into which the employee can allocate his/her 401(k) funds.  Commonly U.S. employers offer a range of mutual fund options to employees.  Employees withdraw funds from their individual 401(k) plans after retiring, in order to pay for their living expenses.</li>
	<li><strong>DC Plan &amp; the Income Statement:</strong> Companies with DC plans will make annual contributions based on the plan’s formula and these contributions will be expensed as incurred.</li>
	<li><strong>DC Plan &amp; Cash Flows:</strong> the pension expense = cash outflow.</li>
	<li><strong>DC Plan &amp; the Balance Sheet:</strong> DC Plans do not create assets and liabilities, so the employer’s balance sheet is not affected.</li>
	<li><strong>DC Plan Management &amp; Risk:</strong> Under a DC plan, the employee assumes all retirement funding risk, as he/she must ensure that enough is saved to the account to fund retirement.  Commonly, the employee makes the plan’s asset investment choices and losses due to asset value declines are absorbed by the employee.</li>
</ul>
<strong>Defined Benefit (DB) Plans</strong>

Under a DB plan, the employer/plan sponsor commits to providing a specified amount of benefits to employees after they retire.  In the U.S., when someone refers to a “pension plan”, the individual is probably referring to a defined benefits plan.
<ul>
	<li><strong>DB Plan Benefits Allocation:</strong> DB plans commonly allocate benefit amounts to employees based on factors such as the employee’s number of years with the company and the employee’s later years’ salary levels.  Employees may be required to work for the company for some specified minimum number of years before they become “vested” in the plan and eligible for plan benefits.</li>
	<li><strong>DB Plan Accounting:</strong> Compared to DC plan accounting, DB plan accounting is significantly more complicated.</li>
	<li><strong>DB Plan Management &amp; Risk:</strong> DB plans are managed by the plan sponsor, which is the employing company.  The company must ensure that the plan is funded and promises made to employees represent a legal obligation that must be publicly reported on financial statements.  Funding is the process by which the employer contributes assets into the DB plan.  The amount that a company contributes to a DB plan is not the same as the DB plan’s expense.</li>
	<li><strong>DB Plan Types (2):</strong> Most commonly, the DB plans are <strong>pay-related</strong> (1), whereby an employer will provide a regular pension check to retirees based on some past salaries.  Less commonly, some DB plans are <strong>non-pay related</strong> (2), where the pension benefits is not based on historic employee pay.  Non-pay related DB plans are rare.</li>
</ul>
 

Defined Benefits Plans vs. Defined Contribution Plans

Three measures of <a title="Defined Benefits Plans vs. Defined Contribution Plans" href="https://financetrain.com/defined-benefits-plans-vs-defined-contribution-plans/">DB plan</a> liabilities under U.S. GAAP are:
<ol>
	<li><strong>Projected Benefits Obligation (PBO)</strong> – PBO is the basis for most pension accounting calculations.  PBO represents the actuarial present value of vested and non-vested benefits earned by employees.  PBO includes assumptions of future employee pay increases.</li>
	<li><strong>Accumulated Benefits Obligation (ABO)</strong> – ABO is the same as PBO with one key exception; ABO is based on current salaries and no consideration is given to future salary increases.  Thus, under a pay-related DB plan, ABO &lt; PBO.</li>
	<li><strong>Vested Benefits Obligation (VBO)</strong> – VBO represents only the present value of vested benefits, therefore any future pension obligations for employees not currently vested will be excluded from the VBO calculation.  Under a pay-related DB plan, for companies with both vested and non-vested employees, VBO &lt; ABO &lt; PBO.</li>
</ol>
<strong>GAAP &amp; Benefit Obligations</strong>

U.S. domiciled public companies do not report any of the three plan liabilities, but PBO will be used in calculating a plan’s funded status for financial reporting.  If a plan is under-funded, then a balance sheet liability exists; if a plan is over-funded, then a balance sheet asset exists.

<strong>IFRS &amp; Defined Benefit Obligation (DBO)</strong>

Under IFRS, only one measure of benefit obligation exists – the <strong>defined benefit obligation (DBO)</strong>.  The IFRS term DBO and GAAP term PBO will be used interchangeably in this tutorial.

Measuring the Defined Benefit Obligation

Pension Expense = increase in the <a title="Measuring the Defined Benefit Obligation" href="https://financetrain.com/measuring-the-defined-benefit-obligation/">DBO/PBO</a> during the accounting period.

<strong>5 Components of Company Pension Expense</strong>
<ol>
	<li><strong>Current Service Cost</strong> = amount by which a company’s defined benefit obligation increases as a result of employee service during the accounting period.  The current service cost is fully and immediately recognized for the accounting period.</li>
	<li><strong>Interest Cost</strong> (same as the discount rate discussed later) = amount by which a company’s existing defined benefit obligation increases as a result of the passage of time.  The interest cost is fully and immediately recognized for the accounting period.</li>
	<li><strong>Return on Plan Assets</strong> = amount of returns generated by plan assets during the accounting period.  Typically, companies apply <strong><em>EXPECTED</em></strong> <strong><em>return on plan assets</em></strong> when calculating pension expense.  Long-term expected return will better reflect the plan’s investment strategy and reduce year to year volatility in the pension expense.  The use of expected returns is allowed by GAAP and IFRS.  Since this is an asset return, the return on plan assets component acts as a contra expense, offsetting other costs.</li>
	<li><strong>Amortization of Past Service Cost</strong> = the difference in the DBO after a plan amendment has been adopted and the DBO before the plan amendment.  The plan amendment could reduce costs, creating a benefit that reduces the pension expense.</li>
<ul>
	<li><strong>GAAP:</strong> this is recorded as a direct to equity adjustment outside of net income, as part of other comprehensive income for the accounting period in which the amendment took place.  A periodic past service cost expense is then amortized to the pension expense over the remaining service lives of the employees covered by the amendment.</li>
	<li><strong>IFRS:</strong> if the amendment affects any vested obligations, then the vested percentage of the past service cost is incorporated into the pension expense for the accounting period of the amendment and the remaining past service cost for unvested obligations is amortized to future pension expense calculations over the course of the related vesting period.</li>
</ul>
	<li><strong>Amortization of Actuarial Gains and Losses.</strong></li>
<ul>
	<li>Actuarial gains and losses arise from:</li>
<ul>
	<li>Differences between expected plan returns and actual plan returns (see #2 of 5); and</li>
	<li>Changes in actuarial assumptions that impact the current service cost (see #1 of 5). Examples: employee life expectancy, salary growth forecasts, interest cost component assumptions, retirement dates, etc.</li>
</ul>
	<li><strong>GAAP:</strong> actuarial gains and losses are recognized as part of other comprehensive income during the period of gain or loss, on the company’s statement of changes in shareholder’s equity.</li>
	<li><strong>IFRS:</strong> actuarial gains and losses do not flow to equity, but are applied to assets or liabilities and are incorporated in the calculation of a net asset or liability on the balance sheet.  A net pension asset is reported as pre-paid pension expense; a net liability is accrued pension expense.</li>
	<li><strong>10% Amortization Expense “Rule”</strong> – companies will not begin to incorporate an amortization gain/loss into its calculation of pension expense until the gain/loss from asset return differences or the benefit/cost from changes to the plan exceeds the greater of 10% of the value of plan assets or 10% of the DBO.</li>
</ul>
</ol>
<div><img class="aligncenter size-full wp-image-5833" title="tax" src="https://financetrain.com/wp-content/uploads/pension_expense.gif" alt="" /></div>
 

Pension Expense (both GAAP & IFRS) for the Income Statement

A Net Asset or a Net Liability Exists (unless DBO value = value of Plan Assets)

<strong>DBO End of Period</strong>

Recall that the <a title="Measuring the Defined Benefit Obligation" href="https://financetrain.com/measuring-the-defined-benefit-obligation/">defined benefit obligation</a> represents the present value of company retirement compensation promises for vested and un-vested employees, with assumptions for future salary increases (GAAP term is projected benefit obligation).

For accounting purposes, the DBO is liability and should be analyzed as such, but GAAP and IFRS require companies to report net position of the plan’s funded status (which can also be positive and thus an asset for public financial reporting purposes).  The funded status is based on the difference between the fair value of plan assets and the DBO.

The ending value for the accounting period’s DBO is outlined below.

<img class="aligncenter size-full wp-image-5833" title="DBO Ending" src="https://financetrain.com/wp-content/uploads/dbo_ending.gif" alt="" />

<strong>Plan Assets End of Period</strong>

Plan assets are investments made on behalf of the interests of the pension beneficiaries in order to provide funding of retirement benefits for current and future retirees.

The ending value for the accounting period’s plan assets is outlined below:

<img class="aligncenter size-full wp-image-5833" title="Plan Assets Ending" src="https://financetrain.com/wp-content/uploads/plan_assets_ending.gif" alt="" />
<strong>A Plan’s Funded Status – the net asset or net liability on the balance sheet</strong>
<div class="formula1">

Funded Status = FV of Plan Assets - DBO

Net Balance Sheet Asset: FV Plan Assets &gt; DBO

Net Balance Sheet Liability:   FV Plan Assets &lt; DBO

</div>
When appropriate actuarial assumptions are applied, the funded status represents the net economic position of the pension plan.

<strong>Funded Status: IFRS &amp; GAAP</strong>

Under both IFRS and GAAP, the net position of the pension is shown on a single side of the balance sheet (either an asset or liability).

It can be argued that separately reporting the plan assets as a standalone asset and the DBO as a standalone liability is more useful for analytical purposes.

There are technical differences between GAAP and IFRS reporting for a defined benefit plan’s funded status and other disclosures and these are attempted to be reconciled as part of the IASB-FASB convergence project.

Defined Benefit Plans & the Company Balance Sheet

In order to manage its defined benefit pension plan, a company must make numerous actuarial assumptions.

The footnotes to financial statements will disclose the following key assumptions:
<ul>
	<li>The discount rate used to create present values (the interest rate);</li>
	<li>The compensation growth rate (projected salary increases); and</li>
	<li>The expected return on plan assets.</li>
</ul>
<strong>Changing the Discount Rate</strong>

The present value of the DBO has an inverse relationship with company changes to the discount rate.
<ul>
	<li>When the discount rate drops, the DBO increases.</li>
	<li>A company can alter its earnings by using an artificially high discount rate.  Even though the interest cost component of the pension expense will be higher, it will be applied to a significantly lower defined benefit obligation base, which lowers the overall pension expense for the accounting period and falsely inflates the company’s net income.</li>
	<li>Theoretically, a company should base its discount rate on market rates for high credit quality bonds with maturities that closely mirror the timing of future pension benefit payments to retirees.</li>
</ul>
<strong>Changing the Compensation Growth Rate</strong>

The present value of the DBO and the current service component of pension expense both have a direct relationship with the compensation growth rate assumption.
<ul>
	<li>When a company increases is its compensation growth rate, the DBO will increase and the current service cost component of pension expense will increase.</li>
	<li>When an analyst reviews the company’s footnotes to financial statements, he/she must check to see that a rational compensation growth rate is assumed by the company.</li>
	<li>The compensation growth rate should be taken into consideration alongside the discount rate.  Inflation expectations should have similar impacts on compensation and interest rates.  When a company increases its discount rate by more than its compensation growth rate, the widening spread between the two tends to reduce the obligation and the pension expense.</li>
</ul>
<strong>Changing the Expected Return on Plan Assets</strong>

Management may be aggressive in its assumption of the expected return for plan assets.
<ul>
	<li>When the assumed return is too high, pension expense will be artificially low and net income will be artificially high.</li>
	<li>The expected return on plan assets presents an opportunity for management to manipulate earnings.</li>
	<li>According to modern portfolio theory, a pension plan’s expected portfolio return should be based on asset allocation.  The analyst should be weary of a company’s reported pension expense, when the expected return is not consistent with the asset mix.</li>
</ul>

The Role of Actuarial Assumptions in DB Plan Accounting

Till now our discussion regarding <a href="https://financetrain.com/defined-benefits-plans-vs-defined-contribution-plans/" title="Defined Benefits Plans vs. Defined Contribution Plans">defined benefit pension</a> reporting has focused on the accounting rules and techniques that company management can apply to pension plan assumptions to window dress financial statements.

When evaluating a company, the financial analyst seeks to determine the true economic positions of the company.  For companies with defined benefit pension plans, the analyst will need to calculate the economic pension expense.

<div class="formula1"><span style="text-decoration: underline;">Economic Pension Expense</span> = the sum of changes to the DBO netted against the actual return on plan assets</div>

<img class="aligncenter size-full wp-image-5833" title="Economic Pension Expense" src="https://financetrain.com/wp-content/uploads/economic_pension_expense.gif" alt="" />

Alternatively:

<div class="formula1">Economic Pension Expense = Δ Funded Status – Company Contributions</div>


Economic Pension Expense

The company’s cash contribution toward funding the pension plan is the cash flow impact (this is different from current period pension expense)

The pension funding contribution is an <a title="Understanding Cash Flow Statement" href="https://financetrain.com/understanding-cash-flow-statement/">operating cash outflow</a>.

When the analyst calculates the company’s true <a title="Economic Pension Expense" href="https://financetrain.com/economic-pension-expense/">“economic” pension expense</a>, he/she will need to compare this against the cash funding contribution.  In the event that the contribution exceeds the economic pension expense, the excess can be viewed as a debt repayment and the excess amount can be designated a financing cash outflow.  Alternatively, if a company’s contribution is less than its economic pension expense, the shortfall can be viewed as a financing cash inflow.

Pensions and the Statement of Cash Flows

<ul>
	<li>A frequent component of corporate executive compensation is stock or share based.</li>
	<li>Stock based compensation can take the form of: stock grants, stock options, stock appreciation rights (SARs), or phantom stock.</li>
	<li>GAAP and IFRS require that share-based compensation is expensed on the basis of fair value.</li>
	<li><strong>Stock Grants:</strong> the employing company gives shares to employees.</li>
</ul>
<div class="formula1">Stock Grant Expense = the fair value of the stock on the grant date recognized over period in which the company benefitted from the employee’s service.</div>
<ul>
	<li><strong>Stock Options:</strong> this form of compensation gives the employee the right to by a specific numbers of shares, at a specific exercise price, within an established period of time.</li>
<ul>
	<li>GAAP and IFRS require companies to use the fair value method to account for stock options.</li>
	<li>The compensation cost is measured on the on the date the options are awarded, based on market prices or by using an options valuation model such as Black-Scholes or the binomial model.</li>
	<li>The compensation cost is allocated to the service period and this is typically the timeframe between the grant date and the date when the employee can exercise the options (the vesting date).</li>
</ul>
</ul>
<strong>Management Assumptions and Stock Option Compensation Accounting</strong>
<ul>
	<li>When a company compensates with stock options, certain valuation assumptions must be employed in order to account for the compensation expense.</li>
	<li>Assumptions that must be made include: stock price volatility, the expected risk free interest rate, and future dividend payments.</li>
<ul>
	<li>Even small changes to the values of these assumptions can have significant impact on the value of the options (and consider that a company may issue hundreds of thousands to executives).</li>
	<li>Both stock option and defined benefit retiree compensation plans bring subjective elements into the financial reporting process.  A well-trained financial analyst will understand how to spot, interpret, and adjust for management accounting choices in order to derive the true economic picture.</li>
</ul>
</ul>

Accounting for Stock (or Share) Based Compensation

Large corporations typically have operations in multiple countries.  The following points outline the accounting processes for currency conversion of foreign based subsidiaries’ financial statements, so the subsidiaries’ financial results can be consolidated with the parent company.
<div>
<ul>
	<li>Presentation Currency vs. Functional Currency vs. Local Currency</li>
	<li>Foreign Currency Translation</li>
<ul>
	<li>Temporal Method</li>
	<li>Current Rate Method</li>
</ul>
	<li>Determining the Functional Currency</li>
	<li>Translation Methods and Financial Statement Effects</li>
	<li>Translation Methods and Financial Ratios</li>
	<li>Accounting for Subsidiaries in Hyperinflationary Economies</li>
</ul>
</div>
<div>We will discuss these points in the following articles.</div>

Financial Statement Consolidation of Multinational Operations

<ul>
	<li>The first step in understanding financial statement consolidation for companies with multi-national operations is learning the three currency classifications.</li>
</ul>
<table class="mytable">
<tbody>
<tr>
<th scope="col">Currency</th>
<th scope="col">Details</th>
</tr>
<tr>
<td>Local Currency</td>
<td>The currency in which a foreign subsidiary executes its business transactions; the local currency may or may not be the same as the functional currency.</td>
</tr>
<tr>
<td class="alt">Functional Currency</td>
<td class="alt">The currency which reflects the primary economic climate of the subsidiary's operations; in other words, it is the currency of cash generation and expenditure. The local currency may be the functional currency, but parent company management has some degree of latitude in designating the functional currency.</td>
</tr>
<tr>
<td>Presentation (or Reporting) Currency</td>
<td>The currency in which the parent company reports its financial statements.</td>
</tr>
</tbody>
</table>
<ul>
	<li style="margin-top: 10px;"><strong>Foreign Currency Translation</strong> = the process by which a foreign subsidiary converts its financial statements to the presentation currency, in preparation for financial statement consolidation with the parent company. In conducting translation, the company must determine:</li>
<ul>
	<li>The exchange rate to be used for translating different financial statement line items.</li>
	<li>The reporting location of the translation adjustment on the financial statements.</li>
</ul>
</ul>

Consolidation: Presentation Currency vs. Functional Currency vs. Local Currency

<ul>
	<li>U.S. GAAP and IFRS require the <a title="Consolidation: Presentation Currency vs. Functional Currency vs. Local Currency" href="https://financetrain.com/consolidation-presentation-currency-vs-functional-currency-vs-local-currency/">functional currency </a>approach for reporting the financial results of a foreign subsidiary in the parent company's presentation currency.</li>
	<li>The functional currency method consists of three steps:</li>
</ul>
<p style="text-align: center;"><img class="aligncenter" src="/wp-content/uploads/currency_method.gif" alt="" width="558" height="360" />
NOTE: Step 2 is only necessary in instances when the local currency is different from the functional currency.</p>

<ul class="list2">
	<li>If Local Currency = Functional Currency ≠ Presentation Currency, then translate from Functional Currency to Reporting/Presentation Currency with the <strong>Current Rate Method.</strong></li>
	<li>If Local Currency ≠ Functional Currency = Reporting Currency, then translate the Local Currency to the Functional Currency with the <strong>Temporal Method</strong>.</li>
</ul>

Foreign Currency Translation

Temporal method is one of the methods of translating a local currency to a functional currency.
<ul>
	<li>In the instances where a foreign subsidiary’s local currency is different from the functional currency, the temporal method must be employed to convert the local currency to the functional currency.</li>
	<li><strong>Temporal Method &amp; the Income Statement:</strong> translation gains and losses that result from translation using the temporal method are reported on the consolidated income statement.</li>
	<li><strong>Temporal Method &amp; Exchange Rates:</strong> in order to employ the temporal method, three exchange rates are relevant.</li>
<ol>
	<li>Current Exchange Rate: rate that exists on the date of financial statement reporting.</li>
	<li>Historical Exchange Rate: rate in place on the date of a specific transaction.</li>
	<li>Weighted Average Exchange Rate: rate that captures the exchange rate movements which took place over the accounting period.</li>
</ol>
</ul>
<ul>
	<li>The temporal method translates the balance sheet first and the income statement second.</li>
</ul>
<strong>Steps in the Temporal Method</strong>

<strong>Step 1:</strong> Translate the different <strong><em>balance sheet</em></strong> items based on their exchange rate rules
<table class="mytable">
<tbody>
<tr>
<th scope="col">Items</th>
<th scope="col">Action</th>
</tr>
<tr>
<td>Monetary Items</td>
<td>Translate using current exchange rates; this includes: cash, accounts receivable, accounts payable, long-term debt, and other assets or liabilities that are measured in currency outside of general price level changes.</td>
</tr>
<tr>
<td class="alt">Nonmonetary Items</td>
<td class="alt">Items reported at historical cost are translated using historical exchange rates that existed when the assets were purchased. This includes: inventories, fixed assets, and intangible assets.</td>
</tr>
<tr>
<td>Capital Stock (Equity) Issued</td>
<td>Translate using the exchange rate in existence on the date of the stock issuance.</td>
</tr>
<tr>
<td class="alt">Retained Earnings</td>
<td class="alt"><em>This is not translated, but is a plug value used in balancing assets with liabilities + owner's equity on the balance sheet.</em></td>
</tr>
</tbody>
</table>
<strong>Step 2:</strong> Move to the <strong><em>income statement</em></strong> and translate items based on their exchange rate rules:
<table class="mytable">
<tbody>
<tr>
<th scope="col">Items</th>
<th scope="col">Action</th>
</tr>
<tr>
<td>Non-Balance Sheet Items</td>
<td>Sales and some expenses (see Balance Sheet items below for the exceptions) are translated using the weighted average exchange rate for the accounting period.</td>
</tr>
<tr>
<td class="alt">Balance Sheet Items</td>
<td class="alt">Expense items linked to specific non-monetary balance sheet items are translated with the associated rate for the balance sheet item. Expenses translated in this manner include: cost of goods sold, depreciation, and amortization.</td>
</tr>
</tbody>
</table>
<strong>Income Statement Translation Gain &amp; the Temporal Method</strong>

Naturally, the income statement and the retained earnings segment of equity on the balance sheet must be consistent.

The following equation must balance:
<div class="formula1">Retained Earnings <sub>End</sub> = RE <sub>Beginning</sub> + Net Income – Dividends</div>

Temporal Method for Translation of Foreign Statements

When the <a title="Consolidation: Presentation Currency vs. Functional Currency vs. Local Currency" href="https://financetrain.com/consolidation-presentation-currency-vs-functional-currency-vs-local-currency/">functional currency</a> needs to be translated to the reporting currency.
<ul>
	<li><strong>Current Exchange Rate (assets and liabilities):</strong> when translating with the current rate method, all assets and liabilities are translated from the subsidiary's foreign currency to the parent's presentation currency at current exchange rates (hence the name "current rate method").</li>
	<li><strong>Historical Exchange Rate (equity items)</strong></li>
<ul>
	<li><strong>Issued Stock:</strong> translate at the rate prevalent when the stock was issued.</li>
	<li><strong>Retained Earnings:</strong> retained earnings start with the prior year amount, plus net income, less dividends to arrive at current period retained earnings. This is the same balance that must hold for the temporal method.</li>
</ul>
</ul>
<div class="formula1">Retained Earnings <sub>End</sub> = RE <sub>Beginning</sub> + Net Income - Dividends</div>
<ul>
	<li><strong>Weighted Average Exchange Rate (income statement items):</strong> revenues, expenses, gains, and losses, are translated into the parent company's presentation currency at the weighted average exchange rate for the accounting period.</li>
</ul>
<h3>Steps in the Current Rate Method</h3>
<ol>
	<li><strong>Income Statement:</strong> translate the income statement first with the weighted average exchange rate.</li>
	<li><strong>Balance Sheet:</strong> assets and liabilities are translated at the current rate; issued capital stock is translated at the exchange rate on the date of issuance; retained earnings is balanced per the equation previously cited.</li>
	<li><strong>Cumulative Translation Adjustment (CTA):</strong> after doing all this work in the current rate method, the balance sheet must be balanced. The CTA is a derived plug number that balances the asset side of the balance sheet with the liabilities and owner's equity side of the balance sheet. The CTA is carried as an unrealized gain or loss on the balance sheet, which is realized when the subsidiary is sold or an impairment charge is recognized.</li>
</ol>

Current Rate Method for Translation of Foreign Statements

<ul>
	<li>When consolidating a foreign subsidiary's <a title="Financial Statements: Structures and Relationship" href="https://financetrain.com/financial-statements-structures-and-relationship/">financial statements</a> with those of the parent company, the correct identification of the subsidiary's functional currency is critical.</li>
	<li>Commonly the subsidiary's functional currency is the local currency, but sometimes the functional currency is the parent's reporting currency or some third currency.</li>
	<li><strong>Selected IFRS Guidance for Determining the Functional Currency:</strong></li>
<ul class="list2">
	<li>The subsidiary's functional currency is the currency that influences sales prices.</li>
	<li>The subsidiary's functional currency is the currency of the country whose regulations and competitive structure influences sales prices.</li>
</ul>
	<li><strong>Selected GAAP Guidance for Determining Functional Currency:</strong></li>
<ul class="list2">
	<li>When the subsidiary is a relatively self-contained, independent business operation, operating primarily in local markets, then the local currency is the functional currency.</li>
	<li>When the subsidiary is heavily integrated with the parent company and it serves as sales outlet type function for the parent, then the subsidiary's functional currency is the parent's reporting currency.</li>
</ul>
	<li>While GAAP and IFRS require certain disclosures regarding the treatment of foreign currency when consolidating multinational operations, parent company management retains some discretion in determining the functional currency. A well trained financial analyst must be aware that two companies in the same industry may use different translation methods. For comparability purposes, it is recommended to move all translation adjustments to equity from the balance sheet to the income statement.</li>
</ul>

Consolidating Financial Statements: Determining the Functional Currency

<strong><a title="Temporal Method for Translation of Foreign Statements" href="https://financetrain.com/temporal-method-for-translation-of-foreign-statements/">Temporal Method</a> &amp; Financial Statement Effects</strong>
<ul class="list2">
	<li><strong>Income Statement Volatility:</strong> Under the temporal method, translation gains or losses are reported directly on the income statement. Therefore exchange rate volatility can create net income volatility for companies consolidating subsidiaries with the temporal method.</li>
	<li><strong>Balance Sheet Exposure:</strong> Monetary assets and liabilities are exposed to translation at current exchange rates. If exposed assets exceed exposed liabilities, then the foreign subsidiary has a net balance sheet exposure. Therefore, a translation loss will occur when the foreign currency weakens. If exposed liabilities exceed exposed assets, then a translation loss will occur when the foreign currency strengthens. It is important to be mindful of the subsidiary's balance sheet exposure and the movement of its local currency when analyzing a company that consolidates with the temporal method.</li>
</ul>
<strong><a title="Current Rate Method for Translation of Foreign Statements" href="https://financetrain.com/current-rate-method-for-translation-of-foreign-statements/">Current Rate Method</a> &amp; Financial Statement Effects</strong>
<ul class="list2">
	<li><strong>Income Statement Stability:</strong> Because the current rate method applies the cumulative translation adjustment to the equity section of the parent's balance sheet, the consolidated net income will be less volatile, when compared to translation under the temporal method.</li>
	<li><strong>Balance Sheet Exposure:</strong> All assets and liabilities are translated at current rates. Given that a subsidiary's assets will exceed its liabilities, a net asset balance sheet exposure is created. Therefore when the foreign currency (subsidiary's local currency) appreciates, the cumulative translation adjustment will be positive.</li>
</ul>
<strong>Translation Methods and Financial Ratios</strong>
<ul class="list2">
	<li>Because the current rate method uses largely (not entirely) the current exchange rate to translate financial items, the financial ratios in the presentation currency will more closely (but not identically) resemble the financial ratios in the local currency. The temporal rate uses multiple exchange rates, so the local currency ratios and the presentation currency ratios are much less comparable.</li>
	<li>Because the current rate method does not translate contributed capital at the current exchange rate, financial ratios which employ both income statement items and balance sheet items, local currency ratios and presentation currency ratios will not be identical.</li>
	<li>Under the temporal method, financial ratios in the local currency can be significantly different from those in the presentation currency.</li>
</ul>
 

Translation Methods and Financial Statement Effects

<strong>GAAP &amp; Hyperinflation</strong>
<ul>
	<li>Under U.S. GAAP a hyperinflationary economy is defined as one whose cumulative three-year inflation rate exceeds 100%.</li>
	<li>When this threshold is broken, the parent company must use the temporal method for translation.</li>
	<li>The use of the temporal method under a hyperinflationary scenario will maintain the value of fixed assets at historical cost.</li>
</ul>
<strong>IFRS &amp; Hyperinflation</strong>
<ul>
	<li>IFRS does not use a numerical threshold, like GAAP.  However, GAAP’s test threshold is still a legitimate test to determine if an economy is hyperinflationary.</li>
	<li>In a hyperinflationary environment, IFRS provides a specific process to restate financial statements.</li>
</ul>

Accounting for Subsidiaries in Hyperinflationary Economies

<ul>
	<li>Spend six to seven hours reading Study Session 6 of the Level II CFA Program Curriculum © taking notes.</li>
	<li>Spend two hours creating flash cards from this study sheet and the official material.
<ul>
	<li>Flash cards do not need to be limited to pure formulas.  For example, some Financial Reporting flash cards may walk through the steps of a complicated accounting method or financial statement revision process.</li>
</ul>
</li>
	<li>Spend six hours taking practice questions.
<ul>
	<li>On the practice questions, the exam taker is recommended to study as many item sets as possible.</li>
	<li>There may be problems which require multiple steps (for example adjusting a financial statement and then recalculating a financial ratio based on the adjusted date).</li>
	<li>Repetition can tremendously help a student become comfortable with more difficult financial reporting questions.</li>
	<li>There is no need to begin practicing under pressure.  Start by doing practice problems open note or open book.  As one develops confidence through practice, then he or she can transition to doing these problems without help.</li>
	<li>Dedicate small parts of future weeks to staying refreshed on Financial Reporting.  This subject is simply too important to study in January or February and then put down until completing the rest of the material in late April or early May.</li>
</ul>
</li>
</ul>
This tutorial gets into the second leg of Financial Reporting and this is premium material for the Level II exam.  Scoring above 70% on Financial Reporting goes a long way towards achieving a pass.  Alternatively, scoring below 50% on Financial Reporting puts a lot of pressure on the candidate to score very high in other sections.

In the second leg of Financial Reporting 2, the tutorial looked at accounting for <a title="Intercorporate Investments Accounting – Ownership Categories" href="https://financetrain.com/intercorporate-investments-accounting-ownership-categories/">intercoporate investments</a>, <a title="Defined Benefits Plans vs. Defined Contribution Plans" href="https://financetrain.com/defined-benefits-plans-vs-defined-contribution-plans/">retirement benefits</a>, <a title="Accounting for Stock (or Share) Based Compensation" href="https://financetrain.com/accounting-for-stock-or-share-based-compensation/">stock based compensation</a> and <a title="Financial Statement Consolidation of Multinational Operations" href="https://financetrain.com/financial-statement-consolidation-of-multinational-operations/">multinational consolidation</a>.  While each of these topics could easily cover an entire item set, a reasonable expectation is that three or all four of these subjects will appear over the course of one to three item sets.  Repetition will be critical to mastering the material.  Learn the processes and decision rules involved with these accounting issues and practice them in item set format over and over.

CFA Level 2: Financial Reporting 2 - Recommendations

Because mortgages are more likely to be prepaid rather than paid off on schedule, mortgage maturity (date the final mortgage payment is due) is not a good measure for the time length of a mortgage.

A more suitable measure is the Weighted Average Life (WAL). It is the weighted average time for principal repayment, that is, the average time it takes for every dollar of principal to be repaid. The time weights are based on the principal payments, i.e., the years with more principal payments will have a higher weight.

Average life is a better measure of length than mortgage maturity.

For a bullet (non-amortizing loan), the Weighted Average Life will be the same as its tenor because the full principal is repaid at maturity.

For a loan with a given maturity, WAL increases with the increase in coupon. This happens because with a higher coupon, the principal payments are further delayed in time. If the coupon was 0, and the loan was amortizing linearly, then WAL will be exactly half of the loan tenor plus half a period. Half a period is added because the payments are made in arrears. So for a 30 year 0% loan, paying monthly, the WAL is 15 1/24 years.

The average life estimate is heavily dependent on <a title="Cash Flows and Prepayment Risk" href="https://financetrain.com/cash-flows-and-prepayment-risk/">prepayment</a> assumptions. We need to make an assumption about the prepayment rate, and estimate the WAL, which will be the simulated average life. Faster prepayment translates to a shorter average life.
<h2>Calculating Weighted Average Life</h2>
Let’s take a simple example to understand how WAL can be calculated.

Assume a $10,000 mortgage with a maturity of 30 years and coupon of 6%. The monthly payments will be $59.96

For this loan, the WAL will be calculated as follows:
<div class="formula1">WAL = (59.96 * 360 – 10,000)/(10,000*0.06) = 19.31</div>
Let’s analyze this calculation. The numerator represents total interest payments, while the denominator represents annual interest payments. You can look at this mortgage as equivalent to a 19.31 bullet (non-amortizing) loan at 6% per annum. Both loans will generate the same interest cash flow. Since the WAL of the 19.31 years bullet loan is 19.31, the WAL of our mortgage will also be 19.31, i.e., the principal will be repaid in 19.31 years.

MBS Weighted Average Life

Financial Reporting Part 2

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COURSE

Financial Reporting Part 2

Lessons

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