CFA L2 FSA Part (1/2) Flashcards

Question

Goodwill

Answer 1

The excess of the purchase price over the net fair value of a company's assets at the acquisition date. Goodwill is not amortized but must be tested for impairment at least ANNUALLY. If impaired, goodwill is reduced and a loss is recognized on the income statement.

Answer 2

Purchase price - (bv of assets * share of company) - [ (the discrepancy of any assets w/ different fair values than book values (fair value - book value)) * share of company ]

Answer 3

(net income of investee * share of company) - (any adjustment made to the fair value at the date of acquisition * share of company)

Answer 4

% acquired ÷ (book value of net assets at beginning of year + net income ÷ dividends) + unamortized excess purchase price

Answer 5

Equity method investments must be tested for impairment. Under GAAP and IFRS: if FV falls below carrying value and the decline is other-than-temporary, the investment is written down and the loss is recognized in the IS. IFRS needs clear evidence of loss in value: loss event, impact on FCFs, or some sort of reliable measurement shows there is loss.

Answer 6

False, neither IFRS nor GAAP allows for the asset to be written up at any point in time.

Answer 7

Upstream: Investee to investor. Any profit on a transaction is in the investee's account. But, if the goods have not been used/sold by the investor, the investor's income statement will not be increased by (investee's earnings * share of company). The investor must eliminate its proportionate share of the profit from the income of the investee. Downstream: Investor to investee. Any profit on a transaction is in the investor's account. The same concept as upstream transactions apply here. The investor must eliminate the proportionate share of the profit.

Answer 8

An investor owns 30% of the investee. During the year, the investee sold $15k in goods to the investor, however, at year end, the investor had 50% of these goods still in inventory. What is the impact to the investor's IS? (15k * .5) * .3 = 2,250 increase in earnings

Answer 9

An investor owns 30% of the investee. During the year, the investor sold $40k in goods to the investee for $50k. The investee sold 90% of the goods by year-end. What is the impact to the investor's IS? Investor profit = $50k - $40k = $10k. 10% of goods remain in investee's inventory, thus investor must reduce income by proportionate share: ($10k * 10%) * 30% = $300 decrease in profit for investor. So total profit = $10k - $300 = $9.7k

Answer 10

False, it usually results in higher earnings.

Answer 11

* Merger * Acquisition * Consolidation ## Footnote * IFRS does not distinguish between different types of combinations. Both GAAP and IFRS only use the acquisition method to account for business combinations.

Answer 12

IFRS previously used this method to account for business combinations, however it is NOW EXTINCT. This method combined the assets and liabilities of two firms and viewed each firm as equal. Key attributes of this method: * Firms are combined using historical BVs. * Operating results from prior periods are restated as though the two firms were always combined. * Ownership interests continue.

Answer 13

Record any finance (debt or equity) raised by the parent for the acquisition in the parent's b/s. If cash was used for the acquisition, reduce parent's cash by the amt spent and list the investment as an asset at purchase price. This is all in the parent's b/s. Do not include the investment line item in the parent's b/s. Create minority interest: share of equity not owned. This obviously will not exist when a company acquires 100% of a company. Calculate goodwill. Combine 100% of assets and liabilities of both firms, after netting out intercompany transactions.

Answer 14

% of subsidiary not acquired * (subsidiary's post-acquisition net assets (assets - liabilities))

Answer 15

Purchase price - [ % of subsidiary acquired * (subsidiary's post-acquisition net assets) ]

Answer 16

1. Combine the post-acquisition revenues of the parent and subsidiary. 2. Combine the post-acquisition expenses of the parent and subsidiary. 3. Create a minority interest item: (% of subsidary not owned * subsidary's post-acquisition NI) NI= #1 - #2 - #3

Answer 17

False, the acquisition method results in higher revenues and expenses (since the parent and subsidiary are combined) but the NIs will be equal under the acquisition method and the equity method.

Answer 18

This is how we account for goodwill when there is an acquisition of less than 100% of the subsidiary. ONLY IFRS ALLOWS PARTIAL GOODWILL. ## Footnote * IFRS gives firms the option to report full goodwill or partial goodwill.

Answer 19

fair value of the subsidiary (purchase price) - fair value of the subsidiary's identifiable NET assets.

Answer 20

purchase price - (% owned * FV of the subsidiary's NET identifiable assets) OR (% owned * full goodwill)

Answer 21

Intangible assets that can be acquired separately. These assets can be amortized over their useful lives. Ex: Patents, copyrights.

Answer 22

Intangible assets that cannot be acquired separately and may have an unlimited life. Cannot be amortized over their useful lives. Tested for impairment annually. Ex: Goodwill

Answer 23

(% not owned) * (purchase price)

Answer 24

% not owned * (FV of net identifiable assets of the subsidiary)

Answer 25

False, the full goodwill method results in higher total assets and higher total equity than the partial goodwill method.

Answer 26

When carrying value > fair value ## Footnote * Impairment is reported as a line item on the IS.

Answer 27

False, goodwill impairments cannot be reversed.

Answer 28

GAAP requires potentially a two step approach. First, determine if carrying value (including goodwill) > FV of the subsidiary; if so, impairment exists. Second, the loss reported in the IS is the difference between the carrying value of goodwill and the implied FV of goodwill. The loss is a part of continuing operations. Implied fair value calculation: FV of subsidiary - FV of subsidiary's net assets. IFRS requires a one step approach. If the carrying value (including goodwill) > FV of the subsidiary, reduce goodwill by this difference and create a one time expense of the difference in the IS. The loss is considered an extraordinary item in the IS.

Answer 29

The higher of (selling price - cost) or (value in use) ## Footnote * Value in use= PV of FCFs

Answer 30

IFRS: Eliminate goodwill down to 0 and if the loss is still more, reduce the value of noncash assets GAAP: Eliminate goodwill down to 0 and if the loss is still more, forget about the excess.

Answer 31

When the purchase price is less than the fair value of the subsidiary's net assets. How to account for this: Both IFRS and GAAP require that the difference between purchase price and fair value of net assets be recognized as a gain in the parent's IS.

Answer 32

A method of accounting for joint ventures that is seldom allowed under IFRS and GAAP. This method is similar to the acquisition method, except the investor only reports the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. Sine the proportionate share is reported, no minority interest is needed.

Answer 33

1. For the group account (consolidated account), take $40,000 + ($16,000 * .8) = $52,800. 2. For the group account, take the $32,000 in company A's other assets and add company B's ($8,000 * .8) = $38,400. 3. Add the group account's CA + other assets= $91,200.

Answer 34

False, in the group account we include the parent's common stock and the parent's R/E. The difference between this and the equity method is that the CL is the parent's + their proportion of the subsidiary's.

Answer 35

False, under the equity method, only the parent's CL, common stock, and R/E is included in the group account. Recall, post acquisition earnings include the parent company's R/E + the parent's share of earnings from the joint venture.

Answer 36

False, net income under the equity method and proportionate consolidation method is the same but revenues and expenses are different. THIS DISTORTS RATIOS.

Answer 37

A joint venture is a separate legal entity. We use equity accounting in this situation. Joint operation is doing business with another company but it's not a separate legal entity. Here, we use proportionate consolidation method.

Answer 38

A legal structure in the form of a separate business entity created by a parent company to isolate certain assets and liabilities. This is often used to reduce financial risk. SPEs can be in the form of corporations, partnerships, joint ventures, or trusts. Typically, the parent company controls the finances/operations of the SPE, while a third party has controlling interest over the equity. Typically the motivation of an SVE is low-cost financing. The SVE can often borrow at lower rates.

Answer 39

A parent company sells an asset to the SPE and the SPE pays cash to the parent company. The SPE acquires the cash by issuing ABSs.

Answer 40

VIEs only exist under GAAP. An SVE that has at-risk equity that is insufficient to finance the entity's activities w/o additional financial support or equity investors that lack decision making rights, the obligation to absorb expected losses, or the right to receive expected residual returns.

Answer 41

True, this changed after Enron to where now companies must consolidate if they can share in the reward. IFRS always made companies consolidate if they had anything to benefit from.

Answer 42

A type of SPE. This is where a sponsoring company (parent company) sells off some of its PP&E to the SPE and then immediately lease it back immediately. The lease is then classified as an operating lease, which recall from L1, is any lease where both the benefits and risks are not substantially transferred. This is often used to boost the d/e ratio.

Answer 43

A type of SPE. This is where loans/mortgages are sold to an SPE which issues MBSs.

Answer 44

A type of SPE. This is where a parent company sells accounts receivable to the SPE which then uses the receivables as collateral to borrow.

Answer 45

A type of SPE. This where an SPE is established to fund R&D w/o having to recognize R&D expense or liabilities in the group accounts. This only works if the companies aren't consolidated.

Answer 46

* SPE is for benefit of the parent company. * Parent company has decision-making power. * Parent company is able to absorb risks/rewards. * Parent company has residual interest.

Answer 47

* Insufficient at-risk investment (typically less than 10% of equity capital): The theory here is that since the SPE doesn't have a lot of equity, if it starts to lose money it'll need a bail out from the parent company. * Shareholders lack decision-making rights. * Shareholders do not absorb expected losses. * Shareholders do not receive expected residual returns.

Answer 48

Contingent assets= never recognized. Contingent liabilities= For the contingent liabilities that can be measured reliably at MV, recognize these at the time of acquisition. In subsequent periods, contingent liabilities are measured at the higher of the value initially recognized or the best estimate of the amount needed to settle the liabilities.

Answer 49

GAAP divides these two things into contractual and noncontractual. Contractual contingent assets and liabilities are recorded at FV on their acquisition date. Noncontractual contingent assets and liabilities are recorded if they are PROBABLE to happen.

Answer 50

They are recorded at FV. The acquirer must recognize the assets and liabilities that the firm being acquired had not recognized.

Answer 51

The asset, liability, or equity is recognized at its best estimated FV. Any changes in value of liabilities affect the IS unless the item is an equity item where then it would settle within equity, not the IS. Under GAAP, any changes in the fair value of a contingent consideration considered an asset affect the IS.

Answer 52

In-process R&D is capitalized as an intangible asset and included as an asset under both GAAP and IFRS. It is subsequently amortized (if successful) or impaired (if unsuccessful).

Answer 53

Restructuring costs are expensed when incurred and not capitalized as part of the acquisition under IFRS and GAAP.

Answer 54

All 3 methods report the same NI. The equity method and proportionate consolidation method report the same equity but the acquisition method's will be higher. Assets and liabilities are highest under the acquisition method and lowest under the equity method. Revenues and expenses are highest under the acquisition method and lowest under the equity method.

Answer 55

* Short-term= less than 12 months (ex: salary) * Long-term= more than 12 months (ex: long-term disability) * Stock-based: options or stock grants * Post-retirement

Answer 56

Difference between the time the stock grant is granted to the employee (offering date) and the time until an employee can sell the stock. This is the schedule over which you gain ownership of various benefits. ## Footnote * For salaries: two weeks * For stock options: several years (typically)

Answer 57

When employees are paid with a company's shares versus cash. Advantages: * No cash outlays for the firm * Aligns mgmt and shareholder interests. Disadvantages: * Dilutes the shares of existing shareholders * Since employees' actions minimally affect the share price their motivation to work hard is limited * Managers may take too much risk if their pay is tied to company performance. If stock is guaranteed, managers may take too little risk.

Answer 58

Stock grants occur when the company pays part of the compensation of the employees in the form of corporate stock. Stock grants often have specific conditions attached for the grants to vest. Accounting treatment: The value of the stock grant is expensed during the vesting period and put in a reserve under equity. Expense= MV at grant date. Upon settlement, the reserve is removed and allocated to common stock and paid-in capital.

Answer 59

Value of stock on grant date * # of shares granted

Answer 60

Restricted: Most of the time, stock grants have some restriction. The most common restriction is a service condition: the # of years until an employee is vested (able to sell the stock), this creates an incentive to stay with the company. Another common condition is a performance condition: where the grant vests upon completion of some performance achievement or market condition (ex: stock price). Unrestricted: There are no conditions.

Answer 61

Similar to performance shares, but unlike performance shares, RSUs are traded for stock when they vest, not upfront at the time of the achievement. If an employee quits prior to vesting, the ownership will be returned to the company. RSUs do not accrue dividends. RSUs are preferred over stock options by employees because they accrue some value if stock price > 0. Value of RSU calculation: (Value of stock on grant date * # of shares granted) - (dividends accrued during the vesting period). ## Footnote * When you're granted stock options, you literally have the “option” to purchase company stock at a specific price before a certain date. Whether, and when, you actually purchase the stock is entirely up to you. RSUs, on the other hand, grant you the stock itself once the vesting period is complete * The key difference between performance stock and RSUs is in how vested shares are calculated. With restricted stock, the company agrees to grant a set number of shares regardless of company performance. The number of shares granted in a performance stock program fluctuates depending on the performance of your company.

Answer 62

* Nature and extent of share-based compensation during the period. * How MV was determined. * Impact on income for the period.

Answer 63

Stock options give the employee the right but not the obligation to buy a set amount of the company's stock at a set price within a specified time frame. Stock options are always subject to vesting schedules. In most instances, option agreements expire once an employee leaves the company, incentivizing an employee to stay. Stock options are non-tradeable call options. If the stock price > exercise price, the employee can exercise the option and earn the difference. If stock price < exercise price, the employee won't exercise. Fair value at grant date= estimated option premium. Service period= difference between grant date and vesting date (first date the options may be exercised). Accounting treatment: Expense is based on FV at grant date. Expense is then allocated straight line to the IS over the vesting period. ## Footnote * Options and stock grants do not result in a liability. * The tax benefits from employee stock options affect CFF.

Answer 64

If there is a similar option, the FV of that similar option can be used. Otherwise, an option-pricing model (such as Black-Scholes) is used. IFRS and GAAP do not mandate a specific kind of model.

Answer 65

Annual expense for options: (2MM * $2.85)/4= $1,425M Annual expense for grants: (1MM * $23)/4= $5,750M Total annual expense for options/grants= ($5,750M + $1,425M)= $7,175M.

Answer 66

Only accounted for at settlement. Calculation: share price at settlement date * # of shares vested

Answer 67

Only accounted for at settlement. Calculation: exercise value * # of options vested OR (stock price on settlement date - strike price) * # of options

Answer 68

When the stock price on the settlement date > the stock price on the grant date, the tax deduction will be higher than the cumulative tax compensation expense. ## Footnote * Tax windfalls reduce tax expense in the income statement.

Answer 69

When the stock price on the settlement date < the stock price on the grant date, the cumulative tax compensation expense is higher than the tax deduction. ## Footnote * Tax shortfalls increase tax expense in the income statement.

Answer 70

Dilutive securities= Securities that increase the # of common shares if exercised and thus reduce EPS. (Ex: convertible stock) Antidilutive securities= Securities that would increase EPS if exercised or converted to common stock.

Answer 71

False, performance shares that vest based on a period of service are usually considered dilutive if the stock price has not declined substantially.

Answer 72

False, dilutive

Answer 73

Computes the net new number of shares from potentially dilutive securities, such as options and warrant, to be used in the denominator of the EPS calculation.

Answer 74

Preferred dividend ÷ # of shares that'll be created if the PS is converted. ## Footnote * If this # is < basic EPS, it's diluted.

Answer 75

[ Convertible debt interest * (1 - T) ] ÷ convertible debt shares ## Footnote * If this # is < basic EPS, it's diluted.

Answer 76

First of all, share-based compensation expense is a part of COGS, R&D expense, and SG&A expense in the IS. If we expect the proportions of share-based compensation expense to each of these three items to remain constant, then we do not need to separate share-based compensation expense out. But if it won't stay constant, then we do have to separate it out. Sources that can help predict change in this expense are historical data, mgmt guidance, and assumptions about reversion to the industry mean. Analysts should also forecast any increase/decrease in anticipated # of shares outstanding. Recall, since share-based compensation expense is not a cash outlay, it should be added back to net income in CFO.

Answer 77

A type of retirement pension plan where the firm contributes a sum each period prior to the employee's retirement account. Listed as pension expense on the IS. Accounting treatment: No impact on b/s. Pension expense in the IS equals employer's contributions each period. ## Footnote * Employee bears the risk because the employer makes no promise regarding the future value of the plan's assets.

Answer 78

A type of retirement pension plan where the firm pays an employee a lump sum or periodic payment each period after the employee retires. Employer bears the risk because the benefit is pre-determined. Typically, firms fund this plan by contributing assets to a pension fund. These assets are then managed to generate the growth necessary to pay the pension benefits as they come due. Accounting treatment:

Answer 79

Difference between the assets in a pension fund and the benefit obligation. If the plan assets > the pension obligation, it's overfunded. If the plan assets < the pension obligation, it's underfunded.

Answer 80

PV of all future pension benefits earned to date based on expected future salary increases. ## Footnote * Assumes firm is a going concern. * Discount rate= yield on investment-grade corporate bonds.

Answer 81

The economic standing of a pension plan. If positive, the pension fund/trust is reported as an asset under IFRS and GAAP. If negative, it's reported as a liability. Beginning funded status calculation: funded status = Beginning plan assets - beginning PBO Ending funded status = FV of plan assets - EOY PBO

Answer 82

BOY PBO + service costs + interest cost +/- actuarial gains/losses +/- past service costs - benefits paid = Closing PBO

Answer 83

An element of PBO. The PV of benefits earned by employees in the current period. This is the change in PBO attributed to employees' efforts during the year.

Answer 84

An element of PBO. When a firm amends its pension plan retroactively (ex: changing the payout from 60% to 65% of final salary), the PBO is immediately increased by the PV of increased benefits already earned. ## Footnote * Under GAAP, changes in past service costs are amortized in the IS over time. * Under IFRS, vested past service costs are recognized immediately.

Answer 85

An element of PBO. The increase in the PBO resulting from the passage of time. GAAP Calculation: PBO at start of period * discount rate PBO at start of period= Beginning PBO + any prior service costs IFRS Calculation: (beginning funded status - past service cost) * discount rate. * If resulting amt is negative, an expense is reported. If positive, it's reported as net interest income.

Answer 86

The employer contributes assets to a fund/trust to satisfy future obligations. The expected return on these plans' assets is used as an offset for the computation of reported pension expense. ## Footnote * This is NOT reported on the b/s, but instead stated in the disclosures.

Answer 87

an estimate or forecast of an uncertain variable or event ## Footnote * Changes in actuarial assumptions are reflected in the IS over time under GAAP. Under IFRS, changes in actuarial assumptions are called re-measurements, which are taken to OCI and not amortized.

Answer 88

An element of PBO. There are two components to actuarial gains/losses: the gain/loss due to a decrease/increase in PBO from changes in actuarial assumptions affecting PBO. The second component is the difference between the actual and expected returns on the pension fund's assets. Both of these components begin in OCI and then under GAAP it's amortized in the IS. ## Footnote * Under IFRS, gains/losses are NEVER amortized. * Under GAAP, gains/losses are amortized using the corridor approach.

Answer 89

Only used for GAAP. For any period, once the beginning balance of actuarial gains/losses > 10% of the greater of the beginning PBO or the plan's assets, amortization is required. The amortization of an actuarial gain results in a reduction to pension cost, whereas amortizing actuarial loss leads to an increase in pension cost.

Answer 90

Fair value of plan assets at BOY +/- actual return on plan assets + employer contributions - benefits paid to retirees.

Answer 91

Net periodic benefit costs + service cost + interest cost - expected return on plan assets +/- amortization of actuarial gains/losses +/- amortization of past service costs

Answer 92

Net periodic benefit costs + service cost +/- net interest expense/income - past service costs Net interest expense/income = (beginning funded status - past service cost) * discount rate ## Footnote * Net interest income/expense is the interest expense reported on the IS. This will likely be a different result than interest expense in PBO due to interest income on plan assets.

Answer 93

* Disclose the main characteristics of the plan and the risks involved. * Identify and explain the figures in the financial statements arising from them. * Describe the amount, timing, and uncertainty of FCFs.

Answer 94

Pensions costs are generally a part of SG&A or COGS which are typically shown as a % of revenue. This is normally fine, however, if a plan is set to change, a separate forecast needs to be made. An underfunded liability should be deducted from enterprise value in a financial model.

Answer 95

False, minority interest is included in the parent's company's equity under the acquistion method only.

Answer 96

False, expected returns on the plan are stated in the disclosures. Funded status is required to be stated on the b/s.

Answer 97

False, they are consistent on the b/s but NOT on the IS.

Answer 98

To facilitate economic decisions

Answer 99

False, revenue should be recognized when earned and payment is assured.

Answer 100

False, during growth, operating cash flow is usually lower than operating income as the firm uses cash to increase inventories and receivables.

Answer 101

Aggressive revenue recognition practices would increase accounts receivable, revenues, expenses, income and stockholder's equity. Ending inventory would decline but by less than the increase in accounts receivable resulting in increase in total assets. Early recognition of revenues also accelerates recognition of expenses (COGS).

Answer 102

False, the IS + OCI is a true measure of economic pension expense. There is smoothing in the IS due to prior service costs or actuarial gains/losses.

Answer 103

Funded status. The funded status is the difference in the PBO and the plan assets. If the PBO exceeds the plan assets, the difference is reported as a liability. If the plan assets exceed the PBO, the difference is reported as an asset. If the amounts are the same, then neither a liability nor asset needs to be reported.

Answer 104

False, pension costs included in the cost of production may be capitaized as part of valuation of ending inventory. When this inventory is eventually sold, such costs are expensed as a component of cost of goods sold.

Answer 105

False, expected return relates to the pension expense, not to the size of the obligation.

Answer 106

False, the MV of plan assets is increased by the ACTUAL return on assets.

Answer 107

False, share-based compensation does not affect shareholders equity nor leverage. Compensation expense reduces net income (and retained earnings) but would increase compensation expense reserve – leading to no net change in equity.

Answer 108

True, compensation expense is based on the MV of the options on the grant date. The compensation expense is then allocated straight line in the IS over the vesting period, which is the time between the grant date and the vesting date.

Answer 109

Employer contributions | Benefits paid is not recognized in CFO

Answer 110

False, D/E is lower under full goodwill than partial goodwill. Since purchase price > prorate share of FVNA, goodwill is positive. Full goodwill > partial goodwill and minority interest under full goodwill will be higher than minority interest under partial goodwill. Because minority interest is part of equity, equity will be higher under full goodwill and debt-to-equity ratio will be lower. Net income would be the same and hence ROE under full goodwill will be lower.

Answer 111

False, when the receivables are securitized, the sponsor removes the receivables from the balance sheet and reports the cash inflow as an operating activity in the cash flow statement

Answer 112

1. Discounting the estimated value of equity by a dilution factor (this entails adding an estimated # of shares outstanding to account for future grants) 2. Deduct share-based compensation expense from estimates of free cash flows and not worry about forecasting dilutive shares.