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Financial Reporting & Analysis Level II – 2016 Topic Weight 15-20% (3 to 4 case studies)

Ankur Kulshrestha, CFA Chartered Accountant, Certified Valuer

M. Com, B. Com (H)

+91 9711 066 000

[email protected]

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Overview of FRA: 6 hours

Three new topics 5.5 hours

Inter-corporate Investments 2.0 hr

Pensions 2.5 hr

Multinationals 1 hr

Level 1 concepts: Inventory, LLA 0.5 hours

Quality of Earnings / Analysis

2

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Inter-Corporate Investments

3

-What would be the impact on your security if the company makes

an investment into any other corporate?

-How would standalone results be different from the consolidated

ones?

-Whether to purchase shares of the group’s holding company (like

Tata Sons) or invest in any of its subsidiary (Tata Steel)?

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Scope of discussion

Different levels of equity acquisition

Passive investments (Marketable Securities)

Active investments

Accounting Treatment of inter-corporate Investments

Equity Method

Proportionate Consolidation

Full Consolidation

Important points

Goodwill Creation and Impairment

Inter-company transfer adjustment

Minority Interest valuation

Variable Interest Entities

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Categories of Inter Corporate Investments

5

Type of method of accounting is dependent on the level of involvement investor company is able to

have in the investee.

To make this criteria objective, % holding has been used a guideline to classify and differentiate

between different types of investments

Ownership % Degree of influence Method of accounting under the

US GAAP

Method of accounting under IFRS

Less than 20% No influence Amortized cost/ Fair value Amortized cost/ Fair value

20% - 50% Significant influence Equity method Equity method

More than 50% Control Full Consolidation Full Consolidation

Joint Venture Joint Control Equity method

Proportionate consolidation is

allowed only selectively

Equity Method is preferred/



Substance over form:

1. If the holding % is more than 50% but there is no control due to barriers like bankruptcy,

government interventions, etc – No Consolidation is done

2. If % holding is 20% to 50% but the investor is not able to exercise any influence – Equity

method is not used

3. If % holding is less than 20% but the investor is able to exercise any influence – Use

Equity Method

1

2

3

4

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Practice Question – Equity Security

6

A company purchased a share at beginning of the year for $90,000. During the year,

dividend of $8,000 was distributed. Fair value of share at the end of the year is

$98,500.

Find out the Balance Sheet value, Income statement impact if you classify the security

into:

1. Held to Maturity

2. Available for Sale

3. Trading

What would be the impact on financial statements if this security was sold for 100,000

next year?

B/S Value Income St OCI Income St. OCI

HTM

AFS

Trading

Next year

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Calculation of Amortized Cost

7

Year Opening Invest Interest Income Coupon Rec Delta Closing Invest

1

2

3

A company purchased a five year 9% bond with FV of $100,000 at beginning of the year.

The bond was issued for $96,209 to yield 10%. The coupon payments are made annually at

year end.

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Practice Question – Debt Security

8

A company purchased a five year 9% bond with FV of $100,000 at beginning of the year.

The bond was issued for $96,209 to yield 10%. The coupon payments are made annually at

year end. Fair value of bond at the end of the year is $98,500.

Find out the Balance Sheet value, Income statement impact if you classify the security into:

1. Held to Maturity

2. Available for Sale

3. Trading

What would be the impact on financial statements if this security was sold for 100,000 next

year?


HTM

AFS

Trading

Next year

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Valuation of Passive Investments – Marketable Securities

OR financial Assets

Securities in which the objective of investment is not to participate in the management of

the investee but earn interest / dividend and Capital gain.

There are two broad options of valuation :

1. Fair Value options: All securities are valued at fair value and the changes in

values are taken to income statement.

The investor need to make this choice upfront and state the same in the

footnotes

2. Classifying the security into the following three categories:

US GAAP (new & Old)

= IFRS Old

Valuation Income

(Dividend /

Interest)

Realized

gain / Loss

Unrealized gain /

loss

Held Till Maturity Historical cost /

Amortized cost

Income Statement

Not recognized

Available for Sale Fair value Equity

Held for Trading Fair value Income

Statement

IFRS has come up with the new IFRS 9 on passive investments. We focus on Old rules

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Valuation of Passive Investments – Marketable Securities

OR financial Assets

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Amortized cost is equal to face value less any unamortized discount or plus any

unamortized premium. It is the present value of the remaining cash flows (coupon and fv)

discounted at YTM (also the market rate of interest at issuance)

In case of debt security: Amortized cost replaces Historical cost for all practical purpose

Under IFRS: Only ON DEBT security - If the unrealized gain / loss for AFS security is

caused due to forex fluctuation, then it is taken to income statement rather than to the OCI.

E.g. US investor purchased a Debt Security in the UK at GBP 100 when the spot rate was

1GBP = 1.2 USD. At the close of the year, the exchange rate was 1GBP = 1.5 USD. Find

out the balance sheet value of the security if it was classified as AFS.

Only Debt securities can be classified as HTM

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Reclassification from one category to another

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HTM 96,830 9,621 3,170

AFS 98,500 9,621 1,670 3,170 -1,670

Trading 98,500 9,621+1670 1,500

Next year

Sometimes its prospective and sometimes it retrospective

From To Treatment

Trading AFS

AFS Trading

AFS HTM

HTM AFS

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Reclassification of marketable securities – Under US GAAP

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From To Treatment

Trading AFS Unrealized gain / Loss previously recognized in Income

statement to not transferred to OCI

AFS Trading Unrealized gain / loss previously recognized in OCI is

transferred to Income Statement

AFS HTM The Fair value becomes the new carrying value for the HTM

security. The Unrealized gain previously recognized in OCI

is amortized over life of the security

HTM AFS The security is valued at the Fair value and the Unrealized

gain / loss is recognized in OCI

Notes:

(1) Standard allows transfer from HTM to Trading directly but not vice versa

(2) Above treatment for Trading category is applicable for Fair Value Option also

(3) Once classified out of HTM, a firm may no longer be able to classify that particular security or

similar securities into HTM in future

Change in classification possible if there is change in intention of holding the security

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Reclassification of marketable securities – Under IFRS

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Notes:

(1) Once classified out of HTM, a firm may no longer be able to classify that particular security or

similar securities into HTM in future

(2) IFRS restricts any movement from / to Trading category and Fair Value option.

From To Treatment

AFS HTM The Fair value becomes the new carrying value for the HTM

security. The Unrealized gain previously recognized in OCI

is amortized over life of the security

HTM AFS The security is valued at the Fair value and the Unrealized

gain / loss is recognized in OCI

Change in classification possible if there is change in intention of holding the security

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Impairment of Marketable Securities Impairment is required if any event which warrants impairment has occurred. Check for impairment at the end

of every reporting period

Since Under fair Value option and for Trading securities, valuation has already been done on fair Value and

difference taken to Income statement, there is no need to impair these

Criteria of impairment

1. For debt: When atleast one loss event has occurred and the impact of such event can be measured on

the cash flows from that security

Likely bankruptcy, default on interest / principle payment,

Does not include any delisting, credit downgrade, lack of liquidity in the security

2. For Equity: If its fair value has experienced substantial or extended decline below its carrying value

Treatment under impairment

1. Debt: Revised fair value is calculated by discounting revised cash flows using YTM at the time of

purchase.

Impairment loss (T/F Income Statement) = Carrying value – Revised fair value

2. Equity: Impairment loss (T/F Income Statement) = Carrying value (which would also be at FV) –

Revised fair value

Reversal of Impairment Loss

•US GAAP: Impairment loss can be reversed on HTM but not AFS

•IFRS: Impairment loss can be reversed on all Debt securities but not on Equity security

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Equity Method of Accounting for Inter-corporate

Investments

Some examples of significant influence:

1. Board representation

2. Involvement in policy making

3. Material inter company transaction

4. Interchange of managerial personnel

5. Dependence on technology

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Ownership % Degree of influence Method of accounting under the

US GAAP

Method of accounting under IFRS










Substance over form:

1. If the holding % is more than 50% but there is no control due

to barriers like bankruptcy, government interventions, etc –

No Consolidation is done

2. If % holding is 20% to 50% but the investor is not able to

exercise any influence – Equity method is not used

3. If % holding is less than 20% but the investor is able to

exercise any influence – Use Equity Method

1

2

3

4

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Investment into Associates – 20% to 50% holding

Ques: Company A invests in the shares of company B and acquire 40% of B’s equity for

$10,000. During the year, B earns a net income of $1,000 and out of this pays a dividend

of $800. You are required to find the following:

What is the value at which the initial investment be recorded in A’s Balance sheet?

What is the impact on Income statement (Equity Income) of A during the year?

What is the final balance sheet at the year end?

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Ques: Company P acquire 30% of Q‟s equity for $1,000 in 2011. During the year, Q

earns a net loss of $ 3,000. During 2012, Q incurred a further loss of $1,000. There were

good sales in 2016 when the company Q makes a profit of $1,200. You are required to

find the following:

What is the value at which the initial investment be recorded in P‟s Balance sheet?

What is the impact on Income statement of P during 2011 and the value in 2011

balance sheet?

What is the impact on the financial statement of P during

2012 and 2016?

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1. Pro rata share of investee‟s earnings/loss: Take it to P&L A/c (non-operating item) and

increase the balance sheet asset with the same amount

2. Dividend received is not recorded in the income statement. It simply reduces the

investments balance since the net worth of the investee reduces on payment of dividend

3. If the investee reports losses, value of investment goes down

4. If investee‟s continuous losses reduce the balance sheet asset a/c to zero, then we usually

discontinue the use of equity method

5. Resumption is done only when the pro rate share of profits exceed the pro-rate share of

losses not recognized during the suspension period

6. Investor can make irrevocable election to report it at Fair Value (unrealized gains to be taken

to P&L a/c)

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When the investor is able to

exercise significant influence

over investee

-Record initial investment at cost

-Report on B/Sheet as Non

Current Asset

-Follow Equity Method

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Special case - Purchase consideration in excess of the

proportionate book value of investee

Ques: Sahara company purchased 40% of KF for $60,000. On the acquisition date

the BV of KF‟s identifiable Net Assets was $100,000. Fair value of KF‟s PPE was

more than its book value by $30,000. The remaining life of the PPE is 10 years using

SLM method. During the year, KF reported its Net income as $80,000 and paid a

dividend of $60,000.

Calculate goodwill created on the acquisition

Calculate the impact on Income statement of Sahara

What is the closing value of the investment a/c in the books of Sahara?

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Special case - Purchase consideration in excess of the

proportionate book value of investee

In a theoretically correct scenario, the amount invested by the investor should be equal to

the proportionate book value of the investee. (This is rarely true practically)

When the amount paid > proportionate book value of the investee,

the excess amount is allocated to the identifiable net assets based on their fair values.

Any remaining excess is considered as goodwill.

In subsequent period, investor recognizes (additional) expense on the basis of the above

allocation.

E.g. if excess of $100 has been allocated to the fixed assets (since their FV must be more than the BV)

and these FA have a remaining life of 2 years, then the investor will also allocate $50 as depreciation by

reducing its value of investment in the balance sheet and reducing its Equity Income

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It is to be noted that the asset in the balance will continue to appear as „ Investment‟

a/c (even goodwill is not shown separately)

A = L + C

Value of

investment a/c

Lower equity Income due to greater

depreciation>> lower profits >> lower equity

$50 $50

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Upstream / Downstream transactions

1. Goods worth $8,000 were sold by investor to the investee at $10,000. All the goods

were lying with the investee by the end of the year. What is the adjustment for profit

required due to this inter-company transaction if ownership % is 30%?

2. Goods worth $8,000 were sold by investor to the investee at $10,000. 50% of those

goods sold during the year. What is the adjustment for profit required due to this inter-

company transaction if ownership % is 30%??

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Other important points 1. Impairment

US GAAP: If the fair value of the investment falls below the value reported under the

Equity Method and the decline is considered to be permanent, balance sheet value is

written down to the fair value

Under IFRS: When atleast one loss event has occurred and the impact of such event can

be measured on the cash flows from that security

Impairment loss is taken to the Income Statement

No reversal is possible even if the Fair value increases in future (Under IFRS and US

GAAP)

2. Inter-company transactions

The proportionate-profits from these transaction must be postponed until the goods are

sold to a third party either in a downstream transaction or a upstream transaction:

a) Upstream : when investee sell goods to the investor

b) Downstream : when investor sell goods to the investee

If the goods have been further sold to any third party, then no adjustment for profit

is required

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Unrealized profit should be deducted from the total equity income as well from the

investment account in the balance sheet

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Issues for analysts

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If investee is profitable and its dividend payout ratio is less than 100%

Usually Equity method results in higher earnings as compared to the accounting methods

used for minority passive investments like held to maturity & available for sale

Analyst should consider the appropriateness of use of equity method for particular

investment depending upon the influence that he is able to exercise.

Compared to consolidation method: Usage of equity method results in reporting of

investee's net asset and liability as a single line item on the investor's balance sheet and thus

ignoring the investee's debt

The pro rata share of the investee's earnings are recognized in the investor's income

statement

But the earnings may not be available to the investor in the form of cash flow(dividends)

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Full Consolidation Method

24

Ownership % Degree of influence Method of accounting under

the US GAAP

Method of accounting under

IFRS










1

2

3

4

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Fundamental behind FULL Consolidation

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1. Strategic Ownership vs Mathematical Ownership

2. Three stage of balance sheet to be prepared by the parent

a) Standalone before acquisition

b) Standalone after acquisition

c) Consolidated after acquisition

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Practice Question

Parent

Book Values

Subsidiary

Book values

Subsidiary

Fair Value

Cash & Receivable 40,000 15,000 15,000

Inventory 125,000 80,000 80,000

PPE 235,000 95,000 155,000

Total Assets 400,000 190,000 250,000

Current Payable 55,000 20,000 20,000

Long term Debt 120,000 70,000 70,000

Total Liabilities 175,000 90,000 90,000

Net Assets 225,000 100,000 160,000

Share holders equity 225,000 100,000

Capital 87,000 34,000

Reserves 138,000 66,000

Question: Parent acquired 90% in the subsidiary by issuing shares worth $180,000.

The fair market value of Subsidiary‟s net assets was $160,000.

You are required to prepare a consolidated balance sheet on the date of acquisition

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Solutions

Parent

Stage 1

Parent

Stage 2

Parent

Stage 3

Subsidiary

Fair Value

Cash & Receivable 40,000 15,000

Inventory 125,000 80,000

PPE 235,000 155,000

Investment Account

Goodwill

Total Assets 400,000 250,000

Current Payable 55,000 20,000

Long term Debt 120,000 70,000

Total Liabilities 175,000 90,000

Net Assets or Total

Equity

225,000 160,000

Capital 87,000

Reserves 138,000

1. Calculation of goodwill (Full Goodwill)

2. Calculation of Minority Interest

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Business Combinations - Non-Marketable

security holding >50% Business Combination involves the grouping of two or more entities into a larger

economic entity

Also called as controlling interest investment and the stake acquired is (generally)

more than 50%

There are three different types of business combinations:

1. Merger: when one company absorbs the other entity completely so that the other entity cease

to exist (100 % acquisition compulsory)

Company A + Company B = Company A (a much larger entity)

2. Acquisition: Where one company acquires a controlling stake in other entity and both the

entities continues to exist (100 % acquisition NOT compulsory)

Company A + Company B = (Company A + Company B)

3. Consolidation: Where a third entity is (newly) formed to take over the net assets of both the

entities (100 % acquisition compulsory)

Company A + Company B = Company C

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IFRS and US GAAP require that all the business combinations be accounted for as

Acquisition, whereby one entity identified as the parent takes control of the other

(subsidiary)’s assets and liabilities

ICICI bank

CRISIL

Centurian Bank of Punjab

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Acquisition Method – 3 major accounting issues

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

2. Goodwill: Initial recognition and subsequent treatment

3. Minority Interest: Recognition and measurement of non controlling interest

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Issue 1- Recognition and measurement of assets and

liabilities of the combined entities

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Identifiable Assets and Liabilities

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

Contingent Liabilities

The parent must recognize any contingent liabilities which can create an

obligation due to past action of the subsidiary

In this relation, any indemnification amount that has been guaranteed by the

seller must be recognized as an asset.

Financial Assets

Reclassification can be done by the parent at the time of acquisition

Goodwill: is equal to the excess of purchase consideration paid over the fair value of

identifiable net assets acquired

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Issue 2 - Method of Goodwill calculation

There are two methods of recognizing goodwill at the time of acquisition:

1. Full goodwill method (compulsory under US GAAP)

2. Partial goodwill method (preferred under IFRS)

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Full goodwill method

Goodwill = Fair Value of the Subsidiary (less) Fair value of total identifiable Net Assets

Partial goodwill method

Goodwill = Acquisition Price (less) Fair value of Proportionate identifiable Net Assets

1

2

Even if the parent has acquired less than 100%, full goodwill method can be

used to value Goodwill

In case of Proportionate consolidation, goodwill is always calculated by Partial Method

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Issue 3 - Minority Interest Valuations

Value of Minority interest depends upon the method of recognizing goodwill

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Full goodwill method

MI = Shareholding % X Fair Value of the Subsidiary

1

2 Partial goodwill method

MI = Shareholding % X Fair Value of Identifiable Net Assets of

Subsidiary

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Case 1 - Steps for preparing consolidated balance sheet when

parent acquires 100% in subsidiary

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

2. Don‟t add Equity accounts

3. Remove the investments in shares of subsidiary from parent‟s B/Sheet

4. Remove all inter company balances (receivables and payables etc.) at full value

5. Equity of subsidiary does not figure into Parent‟s balance sheet

SBI SBH

Owns 100% SBH is a wholly owned

subsidiary of SBI

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Case 2 - Steps for preparing consolidated balance sheet when

parent acquires less than 100% in subsidiary

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1. Add each line item of the subsidiary (100%) with the parent company. Don‟t add

Equity accounts

2. Remove the investments in shares of subsidiary from parent‟s B/Sheet

3. Remove all inter company balances (receivables and payables etc.) at full value

4. Equity of subsidiary does not figure into Parent‟s balance sheet

5. Minority Interest is share of the ‘other investors’ in the net assets of the

subsidiary and is shown in Equity

SBI

HDFC

SBH

Owns 60%

Owns 40%

HDFC will be called as Minority

Interest in the books of SBI when

it consolidates the books of SBH

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Other important points

1. Purchase consideration lower than proportionate fair value of

subsidiary

This case, called Bargain Acquisition, is more or less opposite of goodwill and

treatment is same, both, under US , GAAP and IFRS

Identifiable Assets and Liabilities are recorded at their respective fair values

The difference (Fair value less Purchase consideration) is taken to Income statement

in the year of acquisition

2. Restructuring Costs (Same treatment under US GAAP and IFRS)

Treated as expense in the year when incurred

Not capitalized as a one time expense on acquisition

3. Acquired in-process R & D (US GAAP & IFRS)

Identify the same as a separate Intangible asset and measure at Fair Value

In future, amortise the same if project is successfully completed Else Impair the

same

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Consolidation of Income statement

post acquisition

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Parameter Parent

I/S

Subsidiary

I/S

Sales 100,000 75,000

(Less) COGS 70,000 60,000

(Less) Interest Expenses 10,000 5,000

Net Income 20,000 10,000

Ques: Parent acquired 60% in the subsidiary on Jan1st 2011. Prepare a

consolidated Income Statement for the year ended Dec 31st, 2011

Compare and contrast the figure of each line item reported under following methods

(a) Equity Method

(b) Proportionate Consolidation

(c) Full Consolidation

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Consolidation of Income statement post

acquisition

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Steps:

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

2. Remove all inter company transactions.

3. Arrive at the consolidated profit before Minority Interest

4. Subtract Minority Interest after calculating PAT

5. The balance is added to Parent‟s reserves and share of minority is added to Minority

Interest appearing in Balance sheet

Notes:

1. If the subsidiary has incurred profits >>the value of its equity (or net assets) goes up >>

Value of Minority Interest will also go up

2. Value of consolidated income is not dependent of the method of goodwill valuation

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Practice Question (Contd.)

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Parameter Parent

I/S

Subsidiary

I/S

Sales 100,000 75,000

(Less) COGS 70,000 60,000


Net Income 20,000 10,000

Ques: Parent acquired 60% in the subsidiary. Prepare a consolidated Income

Statement for the year ended Dec 31st, 2011

In a downstream transaction, there are goods worth $10,000 sold at a profit of $4,000. Entire

Goods have been sold by the Subsidiary to a third party. Prepare the consolidated Income

Statement by:

(a) Equity Method



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Parameter Parent

I/S

Subsidiary

I/S

Sales 100,000 75,000

(Less) COGS 70,000 60,000


Net Income 20,000 10,000

Ques: Parent acquired 60% in the subsidiary. Prepare a consolidated Income Statement for the

year ended Dec 31st, 2011

In a downstream transaction, there are goods worth $10,000 sold at a profit of $4,000. 40% of these goods

are in the stock of the Subsidiary. Prepare the consolidated Income Statement by:

(a) Equity Method



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Goodwill Impairment

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Important points:

Goodwill to be recognized only when purchased

Goodwill is neither depreciated nor amortized

Goodwill is tested for impairment atleast annually

Impairment (2 question approach like in case of PPE)

1. Recoverability test – whether to impair?

Goodwill to be impaired when Net book value of reporting unit > FV of reporting unit

2. Loss measurement – how much to impair?

Impairment Loss = Book value of goodwill (less) Implied Fair Value of goodwill

Under IFRS, goodwill impairment is a single step process

Impairment Loss = Book value of CGU (Less) Fair Value of CGU

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Practice Question

Question: Last year, Parent acquired Sub for $1,000,000. Fair value of the Sub‟s net

assets on the date of acquisition was $800,000. At the end of the year, FV of Sub is

$950,000 and FV of Sub‟s Net Assets was $775,000. Assuming a carrying value of Sub

is $980,000, determine whether to impair the goodwill and if yes, by how much By US

GAAP and by IFRS

Question: Parent acquired Sub for $700,000. Fair value of the Sub‟s net assets on the

date of acquisition was $800,000. At the end of the year, FV of Sub‟s Net Assets was

$775,000. Assuming a carrying value of Sub is $780,000, determine whether to impair

the goodwill and if yes, by how much.

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Add each line item of the JV (proportionately) with the parent company.

Remove all inter company transactions (proportionately) if not sold to a third party

Arrive at the consolidated group‟s profit

No need to subtract Minority Interest

Proportionate Consolidation Method

(Allowed only selectively under US GAAP/IFRS)

Income Statement Treatment

Balance Sheet Treatment

Remove the investments in JV by parent from parent‟s B/Sheet

Add each line item of the JV (proportionately) with the parent company.

Do not add Equity accounts. Only parent equity is shown in consolidated balance sheet.

Remove all inter company balances (proportionately) like AR / AP

No Minority Interest

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IFRS suggests 3 forms for JV:

1. Jointly Controlled Operations

2. Jointly Controlled assets

3. Jointly Controlled Entities – Issue of equity to investor, separate legal entity, books of accounts

are maintained,

Some JV do not involve any issue of equity

shares to any investor - No inter-corporate

investment takes place

Steps under Proportionate Consolidation Method

In case of Proportionate consolidation, goodwill is always calculated by Partial Method

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Comparison of three methods – V. Important

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Higher because net Income is same

but equity is lower

Same as

equity method Lower

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Inter-corporate Transactions

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Question: Parent Co. (with 60% ownership) had sold goods worth $20,000 to Sub Co.

during the year post acquisition. On this transaction, profit of $6,000 has been earned.

Payment for this transaction is due at the end of the year. 75% of the stock remains

unsold with the Sub by the close of the year -

What are the transaction that are required to be made in the

a) consolidated income statement?

b) consolidated Balance Sheet?

Question: If the payment for the above transaction has been made during the year, is

there any adjustment that is still required for the consolidated income statement and

Balance Sheet?

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Variable Interest and Special purpose entities

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SPE is a legal structure created to isolate certain assets / liabilities from the main

company. It is created by the primary sponsor who finances its activities

It can take following forms: Corporation, Partnership, joint venture or Trust

VIE is a category of SPE that meets any ONE of the following conditions:

1. Risk-equity is insufficient to finance the entities activities without additional financial

support

2. Equity investors that lack anyone of the following:

Decision making right

Obligation to absorb expected loss

Right to receive residual return

VIE must be consolidated by the primary beneficiary even if the ownership is less

than 50%

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Multinational Operations

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-Adjustments required when transaction take place involving

currency of two different countries

-When assets and Liabilities are in a currency other than the

reporting currency?

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Scope of discussion

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Foreign Exchange Exposure

Transaction in Forex

Foreign Operations

Rules of conversion of foreign operations‟ into home currency

1. Translation - Current Method

2. Remeasurement - Temporal Method

Special case – Hyper-inflationary environment

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Exposure to Foreign currency

Exposure to FC: change in the value of any parameter denominated in money

value terms due to fluctuation in foreign exchange rate

Financial statement are exposed to foreign currency fluctuation from:

1. Transactions denominated in Foreign Currency

2. Consolidation of income statement and Balance sheet of foreign country

operations (Subsidiaries)

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Once a foreign currency FS is converted to the home currency, it is

consolidated using the rules of Inter-corporate Investment

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Exposure 1 - Transaction in foreign currency

Meaning: When a company makes any operational transaction involving currency of

other country

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

US has purchased goods from a supplier in Japan

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

Since there is no equity investment involved, there is no need to consolidate any FS

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Rules of inter-corporate investments do not come into picture

Impact on Financial Statement

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

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

any unrealized gain / loss is T/F Income Statement

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

cash flow and any gain /loss (from the previous balance sheet value) is

recognized in Income Statement

OCI does not comes into picture

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Practice Question

50

Question: You are a firm in the US which sold goods in Europe at € 1,000 on 15th Aug

2011. The payment for the same was made on 2nd Jan 2012.

1 € was equal to 1$ on 15Aug, 1.2 $ on 31Dec, 1.1$ on 2Jan

Sales were initially recorded at?

a) $1,000

b) $1,200

c) $1,500

Balance sheet value of Account Receivable is?

a) $1,000

b) $1,200

c) $1,500

Payment received will be recorded at?

a) $1,000

b) $1,100

c) $1,200

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51

Question (Contd.) : You are a firm in the US which sold goods in Europe at € 1,000 on

15th Aug 2011. The payment for the same was made on 2nd Jan 2012.

€1 was equal to 1$ on 15Aug, 1.2 $ on 31Dec, 1.1$ on 2Jan

Unrealized gain / loss will be taken to?

a) Balance Sheet

b) OCI

c) Income Statement

Value of this unrealized gain / loss during 2011 is equal to?

a) + $200

b) - $200

c) + $100

Loss or gain transferred to Income statement during 2012 is?

a) -$100

b) +$100

c) $200

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Exposure 2 - Foreign country operations

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

foreign currency FS into Home Currency

Local

Currency Currency of the investee’s country being referred to

Functional

Currency

Reporting

(Presentation

Currency)

Currency of the primary economic environment in which the

entity operates. Usually the currency of cash generation and

spending

Determined by the Management (scope of manipulation)

As per IASB, The Management should consider the following

factors while determining the functional currency: The currency that influences sales prices for goods and services

Currency of the country whose competitive forces and regulations

mainly determine the sale price of goods and services

The currency that influences labor, material and other costs

The currency from which funds are generated

The currency in which receipts from operating activities are usually

retained

Currency in which the parent company prepares its Financial

Statements

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Practice Questions

53

Question: A firm in the US has a subsidiary in the Japan. The subsidiary‟s sales are

exports to the Europe and purchases are imports from the Europe.

You are required to find out the following

Which currency will be Reporting Currency ?

a) US Dollar

b) Euro

c) Yen

Which currency will be Local Currency ?

a) US Dollar

b) Euro

c) Yen

Which currency will be Functional Currency ?

a) US Dollar

b) Euro

c) Yen

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Practice Questions

54

Question: Suzuki Motor Corp has a subsidiary in India – Maruti Suzuki India. All major

management decisions are taken in Japan.

Which currency will be the Reporting Currency ?

a) US Dollar

b) India Rupees

c) Yen

Which currency will be the Local Currency ?

a) US Dollar

b) India Rupees

c) Yen

Which currency will be the Functional Currency ?

a) US Dollar

b) India Rupees

c) Yen

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The consolidation of foreign subsidiary is similar to the consolidation of a local

subsidiary.

There are two steps in converting foreign subsidiary‟s financial statements:

1. Conversion from Local currency to Functional Currency

This is also called Re-measurement

Temporal Method is used

Re-measurement usually occurs when a subsidiary is well integrated with the

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

2. Conversion from Functional Currency to Reporting Currency

This is also called Translation

Current Rate Method is used

Translation usually involves self contained, independent subsidiaries whose

operating, investing and financing activities are decentralized from parent

Consolidation of Foreign Subsidiaries

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Some Important Definitions

Clean Surplus: taking any unrealized gain/loss into Income Statement

Dirty Surplus: taking any unrealized gain/loss into OCI > Equity

56

Monetary Assets and liabilities are fixed in amount of currency to be received or

paid and includes cash, receivables, payables and short term and long term debt

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

etc. are examples of non monetary assets

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Determining the Appropriate Translation Method

57

Local

Currency

Functional

Currency

Reporting

Currency

Local

Currency

Functional = Reporting

Currency

Local = Functional Currency Reporting

Currency

Remeasurement Translation

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Translation – Current Method

All Income Statement A/cs Average Rate

All Balance Sheet A/cs (except

common stock)

Current Rate

Common Stock Historical Rate (Date of issue

of stock)

Dividends Rate at the time of payment

(i.e., Historical Rate)

Translation Gains/Losses Report under shareholders'

equity as CTA

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Parameter Conversion Rate

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

Profit

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

different assets and Liabilities being translated as per table below

3. The balancing difference in the balance sheet is the Currency Translation gain or

loss which is part of OCI (and thus part of Equity)

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Practice Question

59

Parameters In Euros

Sales 1,000

(Less) COGS 650

(Less) Depreciation 120

(Less) Interest 70

Net Income 160

Ques: An American company has a subsidiary in Europe whose Financial Statements

are given below. Subsidiary has full control over its decision making. Exchange rates at

different point in times are 1st Jan = $1.1, 31st Dec = $1.3, Average rate = $1.2. Use

Opening rate for Equity conversion. Opening value of Retained Earnings in Subsidiary‟s

books =$840 in reporting currency

Parameters In Euros

PPE 1,500

Current Assets 500

Total Assets 2,000

Long term Debt 600

Current Liability 200

Total Liability 800

Net Assets 1,200

Equity 200

Reserves 1000

Prepare translated Financial Statements for the subsidiary in the Reporting Currency

using Current Rate Method

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Remeasurement – Temporal method

Balance Sheet A/cs

Monetary Assets & Liabilities Current Rate

All other assets and liabilities

,i.e., Non Monetary assets and

liabilities

Historical Rate

Income Statement A/cs

Expenses related to non

monetary assets (Eg. COGS,

D&A)

Historical Rate

Revenues and all other

expenses

Average Rate

Remeasurement gains/losses Recognise in the income

statement

60

Parameter Conversion Rate

1. Balance Sheet is remeasured first as per table below

2. The net difference in the Equity (Closing less opening) is the remeasured PAT

during the year

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

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

statement) is the remeasurement gain / loss which has automatically become part

of the Income statement

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Practice Question

61

Parameters In Euros

Sales 1,000

(Less) COGS 650

(Less) Depreciation 120

(Less) Interest 70

Net Income 160

Ques: An American company has a subsidiary in Europe whose Financial Statements are given

below. Subsidiary does not have any control over its decision making. Exchange rates at different

point in times are 1st Jan = $1.1, 31st Dec = $1.3, Average rate = $1.2. Historical rate for Equity and

PPE $ 0.95, historical rate for inventory and COGS = $1.1, historical rate for depreciation is $1.15.

Opening value of Reserves in Subsidiary‟s books =$840 in reporting currency

Parameters In Euros

PPE 1,000

Inventory 500

Account Receivable 500

Total Assets 2,000

Long term Debt 600

Current Liability 200

Total Liability 800

Equity 200

Reserves 1,000

Prepare Remeasured Financial Statements for the subsidiary in the Reporting Currency using

Temporal Method

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Comparison of two methods

Exposure is equal to net asset

position of the subsidiary

Generally net assets position is

positive

If subsidiary has net assets exposure

and foreign currency is appreciating,

a gain is recognized

Difficult to eliminate exposure by

managing the net assets as it would

result into elimination of

shareholders‟ equity

Current Method Temporal Method

Exposure is equal to net monetary

asset or liability position

Generally firms have net monetary

liability position as only few assets are

considered monetary

If subsidiary has net monetary assets

exposure and foreign currency is

appreciating, a gain is recognized

Firms can eliminate the exposure by

managing monetary assets and

liabilities

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Inventory and COGS – under Temporal Method

Since inventory is a non monetary asset, it should be re measured

using the historical rate

Historical Price in DC = Historical price in LC x Historical Exchange rate

FIFO ending inventory and LIFO COGS are re measured based on

most recent exchange rates

FIFO COGS and LIFO ending inventory are re measured using older

exchange rates

Under the weighted average method, ending inventory and COGS

are re measured at the weighted average exchange rate for the

period

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Practice Question

Transaction Original Value in €

(FIFO)

Purchase 1 of 1 units 10


Sales 1 of 1 units

Closing Stock of 1 unit


(LIFO)



Sales 1 of 1 units


Ques: Find out the value of Closing Inventory (Balance Sheet) and the COGS (Income Statement)

in Reporting Currency under the Temporal Method if the subsidiary follows FIFO


in Reporting Currency under the Temporal Method if the subsidiary follows LIFO

64

$1.1 Older rates

$1.2 Recent Rates

Exchange Rate (1€)

$1.1 Older rates

$1.2 Recent Rates


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Practice Question


(FIFO)



Sales 1 of 1 units



(LIFO)



Sales 1 of 1 units



in Reporting Currency under the Current Rate Method if the subsidiary follows FIFO.


in Reporting Currency under the Current Rate Method if the subsidiary follows LIFO.

65

$1.1 Older rates

$1.3 Closing Rates


$1.2 Avg Rates

$1.1 Older rates

$1.3 Closing Rates


$1.2 Avg Rates

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A quick Summary of the conversion rates

Temporal Method All Current Method

Monetary A&L Current Rate Current Rate

Non Monetary A&L Historical Current Rate

Common stock Historical Historical

Equity (Full) Mixed Current Rate

Revenue and SG&A Average Rate Average Rate

COGS Historical Average Rate

D&A Historical Average Rate

Net Income Mixed Average Rate

Exposure Net Monetary Assets Net Assets

Forex Gain or loss Income statement Equity

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(in OCI)

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Ratio Analysis and comparison

Current method:

Pure ratios will not be affected

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

the original and vice versa. (assuming mixed ratio has income statement

item in the numerator and b/sheet item in denominator)

Temporal method:

Depends on which item has been converted at what rate and what is

the trend in exchange rates

67

Pure ratios: both Nr and Dr are from the same FA – either from income statement or

from the balance sheet

E.g. Current Ratio, Debt to Equity, Proprietary Ratio (from BS) , GP/NP margin, (from Inc St.)

Mixed ratio: Both Nr and Dr are from different FA – one from income statement AND

one from the balance sheet

E.g. ROCE, ROE, Turnover Ratios

This is the comparison between the original FS in Local Currency and finally converted

FS in Reporting Currency

This conversion would have involved either translated or remeasured or both

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Special Case - Subsidiaries Operating in Hyper-inflation

Hyperinflation = Cumulative inflation exceeds 100% over 3 years, defined by FASB.

(CAGR of over 26%).

Value of Local Currency would have been severely depreciated (PP Theory) thus

converting the values into Reporting Currency without adjusting for inflation will reduce

their weight significantly in the Reporting Currency

IFRS :FS are restated for inflation and then translated using rules of Current method

Non Monetary A&L to be restated using price index – change in price index since

acquisition

Not necessary to restate Monetary A&L

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

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

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

Balance Sheet is closed first and the difference takes place in Income Statement

US GAAP: Adjusting non monetary assets and liabilities for inflation is not allowed under

US GAAP

We assume that since LC has been severely depreciated, Functional Currency = Reporting

Currency

Remeasurement is done - Temporal Method is used

68

Once Adjusted for Inflation, we then use only the closing rates of exchange for translation (even for income statement)

therefore no CTA will arise

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Practice Question

69

Balance Sheet 2010 2011

Cash 4,000 5,000

Account Receivable 1,000 10,000

Inventory 25,000 25,000

Total 30,000 40,000

Accounts Payable 10,000 15,000

Common Stock 20,000 20,000

Retained earnings 0 5,000

Total 30,000 40,000

Ques: Balance Sheet for a subsidiary is given below. Price Indices are

1Jan 2011 100

31Dec 2011 160

Average for 2011 130

Prepare an inflation adjusted balance sheet and income statement for the subsidiary as per IFRS

Income Statement For 2011

Sales 15,000

(Less) COGS 10,000

Net Income 5,000

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Employee Compensation and

Pension Obligation

70

-Present Value calculation need to be understood in detail

- Rule of pension accounting for Income statement and Balance sheet

-Rules of adjustment in US GAAP and IFRS need to be differentiated

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Scope of discussion

1. Different types of pension plans

2. Rules of pension accounting under US GAAP

3. Rules of pension accounting under IFRS

4. Share based Compensation

71

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Different types of pension plan

1. Defined Contribution Plan Firm makes a periodic contribution to the retirement fund

Based on factors like no. of years‟ service, last drawn salary, employee age, profits, etc.

No assurance by the firm for the final repayment of the liability

Fund managed by employees

No assurance by the firm for the future value plan assets

Pension expense = contribution made each year.

No liability recognized on the balance sheet

2. Defined Benefit Plan (Main subject matter for discussion) Firm makes a periodic contribution to the retirement fund

Fund managed by the firm through an independent Trust

Investment risk for the fund assets lies with the firm which has the responsibility for the discharge of the retirement obligation

Payment to be made to each employee after the retirement till his / her death

Approximation of several factors involved to estimate the total pension obligation

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Defined Benefit Plan (Overview)

Balance sheet impact Assets – Fair value of the asset in the pension fund

Liability - present value of the amount owed to employee for their service till date (defined benefit

obligation)

Fund assets are compared against fund liabilities

In case the status is overfunded (assets more than liability) – difference is shown on assets side

In case the status is underfunded (liability more than assets) –difference is shown on Liability side

Income statement impact: Pension expense include the following:

Service cost – PV of benefits earned by employee due to their service in the current period

Interest cost = Closing PV of the obligation estimated at the beginning of the year

(less) Opening PV of the obligation estimated at the beginning of the year

Actuarial gain or loss – PV of any change in the future obligation caused because of changes in

assumptions used by Actuarial

Prior service costs – retroactive benefits awarded to employees when a plan is initiated or amended

Expected return on fund assets – it reduced the pension expense. Expected return is used in place

of actual return to reduce the volatility.

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Focus on four main aspects

1. Pension Assets (Balance Sheet)

2. Pension Liabilities (Balance Sheet)

3. Pension Expense (Income St)

4. Analyst‟s adjustment

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Pension Plan Assumptions…

Discount

(Settlement) Rate

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

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

Pension Expense.

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

income investments with maturity profile similar to the future obligation

Rate of

Compensation

Growth

It is the expected average annual rate of compensation increase.

Expected Return

on Plan Assets

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

Expected return on plan assets is recognized as part of pension expense

as a deduction

It is used in place of ACTUAL return to SMOOTHEN the expense

Treatment of difference between Expected and Actual Return is same as

that of actuarial gains/losses. Such amount is clubbed with Actuarial

gains/losses and treated accordingly

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1

2

3

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Projected Benefit

Obligation (PBO)

It is the actuarial present value (at an assumed discount rate) of

all future pension benefits earned to date, based on expected

future salary increases.

The assumptions here are of going concern and that the

employees will work until retirement.

Under IFRS, it is called PV of Defined Benefit Obligation but

calculation is exactly similar to PBO

Under US GAAP

Pension Plan’s Liabilities (PBO)

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Explanation for Factors Affecting PBO

Current Service

Cost

It is the PV of benefits earned by the employees during the current

period

It is the increase in the PBO that is the result of the employees

working one more period

It is immediately recognized as a component of pension

expense in Income Statement.

Interest Cost Increase in the obligation due to passage of time

It is equal to beg. Pension obligation x discount rate

It is immediately recognized as a component of pension

expense in Income Statement.

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Explanation for Factors Affecting PBO

Past (prior)

Service Costs

Gains and losses arising as a result of changes in variables such as

mortality, employee turnover, retirement age and the discount rate.

This also includes any difference between actual and estimated

return on plan assets

Report in OCI and follow Corridor Method for T/F to Income

Statement

Change in

Actuarial

Assumptions

Benefits Paid

It is the change in PBO as a result of the firm adopting or amending

its pension plan.

Report in OCI and amortize over remaining average service life

Pensions paid to employees during the current year.

It reduces the pension obligation (treat it like a pending liability that

has NOW been paid)

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Calculation of Pension Payment and PBO

Ques1: Compute the pension for an employee who has been hired at $10,000 p.a

and is expected to work for 10 years before retiring. During this period, his

compensation is expected to remain stable. Every employee of the firm is eligible for

an annual pension = Salary at the time of retirement (X) 2% (X) No. of years served?

Beginning of the first year

End of the first year

End of the second year

Ques2: Compute the pension for an employee who has been hired at $10,000 p.a

and is expected to work for 10 years before retiring. During this period, his

compensation is expected to grow by 3%p.a. Every employee of the firm is eligible for

an annual pension = Salary at the time of retirement (X) 2% (X) No. of years served?

End of the first year

End of the second year

Ques3: In the above example, calculate the present value of the obligation to the firm

assuming the life of the employee to be 5 years after retirement:

End of 1st year

End of 2nd year

Discount rate applicable is 8%

79

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Calculation of Pension Payment and PBO

Ques4: In the previous question, reconcile the opening and closing balance of the

obligation (PBO) during the second year.

Ques5: Suppose at the end of 3rd year, the company decides to increase the

eligibility of the pension from 2% to 3% of the last salary withdrawn. Calculate the

change in value of the obligation (PBO) due to this change.

Ques6: Suppose the company estimates that the employee will live 7 years (in place

of earlier estimate of 5) after retirement. Calculate the change in value of the

obligation (PBO) due to this change assuming figures of Ques5.

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Opening obligation

PBO (Balance Sheet) Reconciliation

Current Service Cost

Interest Cost

Plan Amendments (Prior Service Cost)

Actuarial gains and Losses

Closing Obligation

+

-

+/-

+

+/-

Benefits Paid

=

81

Note: Firms are required to disclose reconciliation of PBO in the financial footnotes

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Pension Plan Assets and Funded Status

82

Fair Value of plan assets at the beg

+ Actual return on assets

+ Employer contributions

- benefits paid

= FV of plan assets at the end

From opening balance sheet

To Closing balance sheet

Funded Status Fair Value of Pension Plan Assets

(Less) Present value of Cash outflow required to satisfy the pension

obligation

Note

(1):Firms are required to disclose reconciliation of Plan assets in the financial footnotes

(2):The above amount is capped by PV of future economic benefits inform of future refunds or reduced contribution

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Current Service Cost

Pension Expense (Income St.) calculation

Interest Cost

Expected Return on Assets

Amortization of Acturial (gains) and losses

Amortization of past service cost

Pension Expense

+

=

+/-

-

+

83

Due to

pension

liability

Due to

pension

asset

Net Charge

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Effect of changing plan assumptions on Benefit Obligation

Directional Analysis for an analyst

84

Increase Discount

Rate

Decrease Rate of

compensation growth

Increase Expected

Return on Plan

Asset

PBO Liability Decrease Decrease No Effect

Pension Plan

Asset

No Effect

No Effect

No Effect

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Directional Analysis for an analyst

85

Effect of changing plan assumptions on Pension Expense

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Practice Questions

86

The financial statement of ABC company stands as follows:

Opening PBO 435

Current Service Cost 63

Interest Cost 29

Prior Service Cost 100

Benefits Paid (144)

Closing PBO 483

Fair value of Plan asset 522

Actual Return on asset 77 (32 is exp)

Employer Contribution 148

Benefits paid (144)

Closing Fair value 603

Ques1: Pension expense for the year is equal to

A. 15

B. 60

C. 160

Ques2: The funded status on Closing date is equal to:

A. Under funded by 12

B. Under funded by 120

C. Over funded by 120

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Practice Questions (Contd.)

87

Ques3: For a company with a young workforce, increase in discount rate will impact

PBO and Pension Expense in following manner:

A. Decrease the PBO and increase Interest Cost

B. Decrease the PBO and decrease Interest Cost

C. increase the PBO and decrease Interest Cost

Ques4: For a company with old workforce, increase in discount rate will impact PBO

and Pension Expense in following manner:

A. Decrease the PBO and increase Interest Cost

B. Decrease the PBO and decrease Interest Cost

C. increase the PBO and decrease Interest Cost

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88

Ques3: For a company with a young workforce, increase in discount rate will impact

PBO and Pension Expense in following manner:

A. Decrease the PBO and increase Pension Expense

B. Decrease the PBO and decrease pension expense

C. increase the PBO and decrease pension expense

Ques4: For a company with old workforce, increase in discount rate will impact PBO

and Pension Expense in following manner:

A. Decrease the PBO and increase pension expense

B. Decrease the PBO and decrease pension expense

C. increase the PBO and decrease pension expense

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89

Ques5: PBO for a company is $60 and prior service cost is $10. Fair value of the plan

assets is $40. Under US GAAP, what should be the balance sheet value of the plan

asset / liability

A. $10 Liability

B. $10 assets

C. $20 Liability

Ques6: All else equal, the decrease in discount rate will have what impact on the

funded status:

A. Increase

B. Decrease

C. No Effect

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Explaining Corridor Method

When it is used? Used to recognize AGL in Income Statement that were taken to OCI (and

not to Income Statement)

The amount calculated as per this method is amortized over average

service life

90

Calculation

under CORRIDOR

METHOD

Take the opening balances of PBO and FV of plan assets

Take the one which is higher

Take 10% of it

This is the corridor (max range available to the company)

If the unrecognized AGL exceed this range, then this excess needs to be

amortized

The amortization will be over expected average remaining service lives

of the employees

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Rules under IFRS

91

1. Pension Assets (Balance Sheet) – same as US GAAP

2. Pension Liabilities (Balance Sheet) - same as US GAAP

3. Pension Expense (Income St) - Different

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Pension Plan Assumptions…

Discount

(Settlement) Rate

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

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

Pension Expense.

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

income investments with maturity profile similar to the future obligation

Rate of

Compensation

Growth

It is the expected average annual rate of compensation increase.

Vesting proportion

Pension entitlement comes after completing few conditions in the

employment contract

Some employees do not meet those…Some do.

Those who do not meet the criteria, don‟t get any benefit.

92

1

2

3

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Pension Expense Under IFRS

93

US GAAP IFRS

Current Service

Cost

Expense immediately

Interest Cost Expense immediately

Prior Service Cost -T/F OCI in current yr

-T/F Income St over average

service life

Expense immediately

Actuarial Gain /

Loss

-T/F OCI in current yr

-T/F Income St using Corridor

Method

-T/F OCI in current yr

(Remains in OCI)

Expected Return

on Plan Assets

One of the Plan‟s separate

assumption

Same as the DISCOUNT

RATE used

1

2

3

4

5

Add

Add

Add

Less

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Directional Analysis for an analyst - IFRS

94

Effect of changing plan assumptions on Pension Expense

No separate

assumption of

expected Rate of

Return on Plan Asset

Increase

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Practice Questions

95

Fair value of Plan asset 522

Actual Return on asset 77 (Exp ret is 32)

Employer Contribution 148

Benefits paid (144)

Closing Fair value 603

Remember: In IFRS: expected return is based on the DISCOUNT Rate only and a

separate assumption is not taken

The financial statement of ABC company stands as follows:

Opening PBO 435

Current Service Cost 63

Interest Cost 29

Prior Service Cost 100

Benefits Paid (144)

Closing PBO 483

Ques1: Pension expense under IFRS for the year is equal to

A. 15

B. 60

C. 160

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Total Pension Cost / Expense

96

It is the ACTUAL loss to the company because of pension related adjustments

Definition 1

Total Pension Cost = Current Service Cost + Interest Cost + Total Actuarial loss(gain) +

Total Prior Service Cost – Actual Return on Assets

Definition 2

Total Pension Cost = Firm‟s Actual Contribution – Change in Funded Status (Closing – Opening)

It is also referred to as Economic Pension Expense (No Impact of amortization)

Both the equation will give the same answer

Note: Funded status is Assets - Liabilities

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Other Important Points

1. Inclusion of Pension cost in Inventory Valuation

With reference to Inventory – Product Costs are capitalized (not expensed)

Pension cost included in COGS is treated like a direct expense (like Salary)

and Matching principle is applied

a) Added in closing inventory‟s valuation

b) Taken to Income statement when the Inventory is eventually sold

Pension expense for employees working only in Manufacturing can be

included (part of COGS) since administrative and Selling OH are period costs

2. Presentation in Income Statement

Under US GAAP, all components of Pension expense to be shown as a

single line item

Under IFRS, different components can be taken into different heads

a) Current Service + Prior Service Cost >> As operating expense

b) Interest Cost >> Under Interest Expense (non-Operating expense)

c) Expected Return on Asset – Non-operating Income

(Actual Gain/Loss does not come to Income statement at all) 97

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Analyst’s Adjustments

Operating vs Non Operating - Difference in Classification in Income Statement a) Only Service cost should be treated as operating expense

b) Interest cost should be added to interest expense and

c) ACTUAL (not expected) return on plan assets be added to non-operating income.

98

Impact on cash flows (Analyst’s adjustment)

Accountant has treated entire contribution made out of CFO (pension being an operating expense per se)

If contribution to pension fund is more than the Total Pension cost (i.e Funded Status has increased)

a) It is deemed as extra payment for the principal of the loan. Hence the incremental cash outflow

should be classified as Financing rather than Operating.

b) This extra payment should be added back to CFO and deducted fro CFF

Opposite adjustment will be made by the analyst when the contribution to pension fund is less than the

Total Pension cost

Gross vs Net presentation of Pension Liability

Netting off impacts different ratios since its understate both Liabilities as well as Assets

Different Pension Plan Assumptions to be standardized

1

2

3

4

5

Differences between US GAAP and IFRS in Pension expense to be corrected

Analyst can use Comprehensive Income in place of Net Income for his ratios

This is similar to presentation under IFRS

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Share based Compensation These are in addition to pension plans and other post retirement benefits

It has the advantage of motivating the employee to stay in the company without disbursing cash from

the company

When granted to employees, existing share capital increases which has the impact of dilution of

control for the existing shareholders

Generally of two forms:

1. Stock Grants - Compensation expense based on the market value of share on the date of grant

2. Stock Options -Compensation expense based on the Fair value of option on the date of grant

Compensation expense is allocated to income statement over the service life (time between

grant date and vesting date)

Different Dates:

Grant date: when the option was granted to the employee

Vesting date: when the employee became eligible to exercise the option

Exercise date: when the employee actually exercises the option

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Income reduces but Equity share capital increase by the same amount hence there

is no change in equity

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Fair Value of the Option

FV is based on the similar option‟s value (if available) OR Use of Option Pricing

Model like Black-Scholes

Following inputs are required for valuation of the option:

1. Exercise Price

2. Stock Price at the Grant date

3. Expected Term

4. Expected Volatility

5. Expected Dividend

6. Risk Free Rate

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Differences between US GAAP & IFRS (L-II)

# Point of difference US GAAP IFRS

1 In case of AFS Debt securities, if

unrealized gain / loss is caused

due to forex fluctuation

Taken to the equity directly Taken to income statement

rather than to the equity

directly.

2 Change in classification of

Marketable securities – Trading

and Fair Value Option

Trading / Fair Value option

category can be reclassified from

/ to AFS category

Reclassification possible only

between HTM and AFS

3 Reversal of Impairment Loss on

Debt Securities

Allowed only for those classified

under HTM

Allowed for all the Debt

securities irrespective of the

classification

4 Method of calculation of Goodwill

when the investor can exercise

Control over investee

Full Goodwill Method is

compulsory

Partial Goodwill Method is

preferred

5 Recoverability test for

Impairment of Goodwill

Applied before actual loss

calculation

Not applied

6 Formula for Impairment loss

calculation

= Book value of goodwill (less)

Implied Fair Value of goodwill

=Book value of CGU (Less)

Fair Value of CGU

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Differences between US GAAP & IFRS (L-II)

# Point of difference US GAAP IFRS

8 Conversion of a subsidiary in

case of any Hyper-inflationary

environment

Don‟t follow Current rate

method in any case. Follow the

Temporal Method only.

Adjust the original figures for

inflation using price index and

then follow Current method

9 Present Value of Future

Pension outflow

Called as PBO (Projected

Benefit Obligation)

Called as PV DBO (PV of

Defined Benefit Obligation)

10 Treatment of Actuarial Gain /

Losses

To be taken to OCI and then

amortize using Corridor

Method

To be taken to OCI and remains

there ONLY

11 Treatment of Past Service Cost Taken into OCI and then

amortized as per average

service life of the employee

Taken into income Statement

12 Presentation of Pension

Expense

All the components are to be

shown together as “pension

expense” under operating

expense

All the components can be

shown separately as per their

nature

13 Use of Corridor Method To amortize the AGL parked into

OCI

Not Required

14 Expected Return on Plan

Assets

Separate Assumption by

Actuarial

Equal to the discount Rate

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