CFA Exam – Level 2 2011… (after) thoughts

I went into the exam pretty confident and well prepared after learning my lessons from my first unsuccessful attempt last year… but I certainly wasn’t prepared enough… I give myself only a 60% chance of passing vs 50/50 last year.

I think the exam was pretty difficult and I was surprised at the topic area coverage…

• I believe the Schweser instructors mention that anything is fair game on the exam and it couldn’t be far from the truth for Level 2 2011.
• I had not seen about 30% of the questions in any of the 3 mock exams I did (CFA 2010 & Schweser)…
• The focus is on testing the theoretical understanding and you definitely need to understand the concepts… memorizing will not go very far.
• I would say all of the new material introduced for 2011 was thoroughly tested…

All in all… a difficult exam.

I enjoyed writing the summaries and I referred to them during review. I will continue doing to do so after the exam results… hopefully I will only write for Level 3 material.

Best luck!

Update: I removed some exam information on request from CFA Institute.

Multinationals Operations – How to translate and report financials of a subsidiary to it’s parent

CFA Level 2 – Financial Reporting & Analysis; Study Session 6, Reading 25 in 2011 textbook/Reading 23 in 2010 textbook.

This is okay material… interesting but very mechanical and process oriented

Terminology & Formulae

1. I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows
2. R/E = Retained Earnings, SH Equity = Stockholders/Shareholders Equity,
3. FX = Foreign Exchange, LC = Local Currency, FC = Foreign Currency
4. COGS = Beg. Inventory + Purchases – Ending Inventory
5. Opening R/E + Net Income (plug) – Dividends = Closing R/E or
6. Net Income (plug) = Closing R/E + Dividends – Opening R/E

Methods of FX Translation

• Functional Currency = Reporting Currency, use Temporal/Remeasurement Method to Convert Local Currency to Reporting Currency
  • subsidiary is well integrated with the parent company
• Functional Currency ≠ Reporting Currency, use Translation/All Current Rate Method to Convert Local/Functional Currency to Reporting Currency
  • subsidiary is relatively independent of the parent company

Temporal Method

These are the steps for converting subsidiary balance sheet from local currency to reporting currency

A. Steps to convert Balance Sheet

1. Convert monetary assets (cash & accounts receivables) at current rate, inventories at provided rate or historical rate and PP&E at historical rate to get Total Assets
2. Convert monetary liabilities (accounts payable & debt) at current rate & common stock at historical rate
3. Use law of Balance Sheet to calculate ending Retained Earnings as:
   • Retained Earnings = Assets – Liabilities – Common Stock

B: Reconciliation of Retained Earnings (R/E) to calculate Net Income

Calculate Net Income using formula 6 above:

Net Income = Closing R/E

+ Dividends

– Opening R/E

If there is no FX gain/loss, then the above Net Income figure will match the Net Income on the I/S as calculated below. However, if there is an FX gain/loss, then the two won’t match and the above Net Income figure will be used to calculated a ‘plug’ figure which will be the FX gain/loss to ‘balance’ the I/S

C: Steps to convert Income Statement

1. Convert everything except at COGS & depreciation at current rate
2. Convert depreciation at historical rate
3. Calculate COGS with mixed rate (see formula 4 above):
   • COGS = Beg. Inventory (historic rate)  + Purchases (average rate) – Ending Inventory (current rate)
4. Plug Net Income from Step 4 above and calculate FX Gain/Loss

All Current Method

Apply above steps in reverse order… literally

1. Calculate Net Income from Income Statement, all items at average rate
2. Calculate ending Retained Earnings using formula 5 above
   • Closing R/E = Opening R/E (historic rate) + Net Income (from step 1) – Dividends (historic rate)
3. Convert all B/S assets & liabilities at current rate and common stock at historical rate
4. Use Closing R/E from step 2 to force the B/S to balance (A = L + E) by including FX gain/loss as Cumulative Translation Adjustment (CTA) in the shareholder’s equity section
   • CTA = Assets – Liabilities – Retained Earnings

 

Comparison of Temporal vs. All-Current Methods

(Recall that, if EUR is the local/base currency & USD is the foreign currency, then when LC appreciates, USD/EUR increases)

• LC Appreciation (quoted as FC/LC):

End Rate > Average Rate > Beg Rate
1.7 $/€ > 1.6 $/€ > 1.5 $/€

• LC Depreciating (quoted as FC/LC):

End Rate < Average Rate < Beg Rate
1.5 $/€ < 1.6 $/€ < 1.7 $/€

 

Effects of Currency Fluctuation on Transaction Exposure

Effects of Currency Fluctuation on Parent Company’s Balance Sheet

(This is different from the effects of currency fluctuation on transaction exposure above)

How to Account for Intercorporate Investments (joint ventures, subsidiaries, mergers, acquisitions)

CFA Level 2 – Financial Reporting & Analysis; Study Session 6, Reading 23 in 2011 textbook/Reading 21 in 2010 textbook.

Terminology

I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows

I find this basic M&A accounting read very interesting because:

1. We live in a flat globalized world with a complex intertwined web of global corporations…
2. This knowledge can be applied immediately with the recent pickup in M&A activity and IPOs
3. You can check yourself if you lost money as a tax payer in US Treasury’s investment in Citigroup, BOA!

Investments in other corporations for accounting can take the form of:

1. Investments in financial assets
2. Investments in associates
3. Joint Ventures
4. Business Combinations
5. Special Purpose Entities alphabet soup (SPV, SIV, VIE, etc).

Investments in financial assets:

1. Held-for-trading (e.g. proprietary trading, parking cash in short-term liquid investments like treasuries, ABCP, etc)
2. Available-for-Sale
3. Held-to-maturity

 

Accounting treatment of investments in financial assets where investor does not have significant influence for both IFRS & US GAAP

 

• US GAAP: All unrealized gains and losses on Available-for-sale securities are reported in other comprehensive income (OCI) in the equity section of B/S.
• IFRS: Unrealized Foreign Exchange G/L on Available-for-sale securities are recognized on I/S and non-FX unrealized G/L as OCI on B/S

Reclassification of Investments in Financial Assets:

• IFRS does not allow reclassification
• US GAAP allows reclassifying Available-for-Sale securities as Held-to-Maturity and vice versa.

 

Quick summary (via Schweser) of accounting treatment based on % ownership… for both IFRS & US GAAP

According to US GAAP, what matters is the degree of influence… even if % ownership is less than 20% but if an investor exerts significant influence, then equity method is used.

Equity Method Investment:

1. Requires the investor to recognize proportionate share of income as earned on I/S.
2. Carried at cost, plus its share of post-acquisition income (after adjustments) net of dividends.
3. Reported as a single line item on the balance sheet and on the income statement.
4. Dividends received are not recognized on investor’s I/S but instead reduce the Investment account on B/S.

US GAAP classifies Business Combinations as

1. Merger: Acquirer + Acquired = Acquirer
2. Acquisition: Acquirer + Acquired = Acquirer + Acquired (subsidiary of Acquirer)
3. Consolidation: Acquirer + Acquired = New Company

IFRS does not make such distinctions

Acquisition Method

1. All assets, liabilities, revenues & expenses of a subsidiary are combined on a line-by-line basis with the parent.
2. If the parent owns less than 100% of the subsidiary, a proportionate share of subsidiary’s net assets on B/S and net income on I/S is included as a minority/non-controlling interest account.

Proportionate Consolidation Method (Joint Ventures, IFRS only)

1. Similar to Acquisition method except, investor includes only proportionate share of assets, liabilities, revenues & expenses on a line-by-line basis

Special Purpose Entity (SPE)

1. IFRS requires sponsor of SPE to consolidate if sponsor controls SPE
2. US GAAP requires primary beneficiary of Variable Interest Entities (VIE) to consolidate VIE
3. In other words, if an entity receives the majority of expected returns, losses or residual benefits of an SPE/VIE, then the entity has to consolidate the SPE/VIE.

Comparison of Methods

I will leave Goodwill for another post…

How to Account for Pension Benefits – Part 2… fun stuff!

CFA Level 2 – Financial Reporting & Analysis; Study Session 6, Reading 24 in 2011 textbook/Reading 22 in 2010 textbook.

Part 2 of 2 (longggish…)

This post talks about Pension Accounting (obligation, asset/liability, funded status & pension expense), which I find is very interesting and current…I think it helps to throw some perspective on the recent uproar in opposition to unions, governments & corporations switching from defined benefit to defined contribution pension benefits, resentment towards public sector compensation

It is widely assumed that this is a challenging topic but I think it is relatively easy…there are a few key points:

1. Understand terminology (make sure you have read Part 1)

2. Remember that Assets = Liabilities + Equity

3. Because we want to compare financials across 2 accounting standards, we need to make adjustments and ensure that results reconcile after adjustments…

4. Info to make adjustments appears in footnotes in both standards

Balance Sheet – Pension Asset/Liability

Reconciliation of PBO between start and end of year (disclosed in footnote)

Beginning PBO

+ Service Cost

+ Interest Cost

+ Plan Amendments

± Actuarial (gains)/losses

– Benefits Paid

= Ending PBO

How to Account for Pension Benefits – Part 1 – …definitions!

CFA Level 2 – Financial Reporting & Analysis; Study Session 6, Reading 24 in 2011 textbook/Reading 22 in 2010 textbook.

Part 1 of 2 – Types of Pensions Plans, Assumptions of Pension Plans, Impact of Assumptions on Obligations

Terminology & Formula

1. I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows

2. PBO = Projected Benefit Obligation, ABO = Accumulated Benefit Obligation, VBO = Vested Benefit Obligation

Defined Benefit vs. Defined Contribution

	Defined Contribution	Defined Benefit
Risk	Employee	Employer
Asset Ownership	Employee owns assetsEmployer acts as agent	Employer owns assets via TrustEmployee is beneficiary
Who manages assets?	Employee	Employer via Investment Manager
Pre-funding	n/a	Contributions to Pension Trust
Income Statement	Employer Contribution = Expense	Expense Contribution
Balance Sheet	Exists on B/S only if there is Excess/Shortfall in payments relative to specified contribution
Issues for Analyst	None	Headache!

Types of Defined Benefits

PBO	ABO	VBO
PV of future pension benefits earned to date based on expected salaries over time	PV of future pension benefits earned to date based on current salary	Portion of ABO that has vested (full pension is not always offered on day 1 of employment)
Assumes employee works till retirement
Estimate of liability on a going concern basis	Estimate of liability on a liquidation basis

PBO is by far the most important and the rest of this reading focuses on PBO.

Components of PBO

· Service cost – PV of pension benefits earned for 1 extra year… i.e. pension benefits earned this year.

· Interest cost – increase in PBO resulting from passage of time… e.g. interest earned on prior year’s PBO

· Actuarial Gains/Losses – resulting from change in actuarial assumptions like retirement age, discount rate, rate of salary increase, mortality, etc

Impact of Assumptions on PBO

Source: Schweser Level 2 2010

 

The above three assumptions are required to be disclosed in the financials.

Assumptions should be consistent internally and over time i.e.

1. Compensation growth rate should be in line with inflation rate

2. Discount rate should be inline with expected rate of return on assets

Implications for Financial Statements & Ratios of Capitalizing vs Expensing Long Lived Assets

Summary of new* reading in 2011– Implications for Financial Statements & Ratios of Capitalizing vs Expensing Long Lived Assets (longish…even after dividing chapter in 2 parts)

CFA Level 2 – Financial Reporting & Analysis

Study Session 5, Reading 22 in textbook

*(Like the last post, I am certain I have read some of this material before… and it was in 2009 Level 1 – reading 36 in SS9!)

——————————-

Terminology & Formula

1. I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows

2. Ending shareholders’ equity = Beginning shareholders’ equity

+ Net income

+ Other comprehensive income

- Dividends

+ Net capital contributions from shareholders

3. Return on Equity (ROE) = Net Income ÷ Average Shareholder’s Equity

4. Interest Coverage Ratio = EBIT ÷ Interest Expense

5. Operating Income = EBIT = EBITDA – Depreciation – Amortization

6. EV/EBITDA = Enterprise Value ÷ EBITDA

——————————-

Capitalizing vs. Expensing

Source: Kaplan Schweser Level 1 Curriculum 2009

Adding few more items not in the above table…

Impairment & Revaluation of Long Lived Assets

Summary of new* reading in 2011– Long-Lived Assets: Implications for Financial Statements & Ratios – Part 2 of 3

CFA Level 2 – Financial Reporting & Analysis

Study Session 5, Reading 22 in textbook

*(Like the last post, I am certain I have read some of this material before… Yes! CFA Level 1, 2009 – reading 36 in SS9!)

-+-+-+-+-+-+-

Terminology & Formula

1. I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows, PPE = Property, Plant & Equipment

2. Historical Cost = Net PPE + Accumulated Depreciation

3. Estimated Total Useful Life = Time Since Purchase (Age) + Estimated Remaining Life

- Which is equivalent to (divide #2 by Annual Depreciation Expense):

4. Estimated Total Useful Life = Historical Cost ÷ Annual Depreciation Expense

5. Average remaining Useful Life of an Asset = Net PPE ÷ Annual Depreciation Expense

6. Average Age of an Asset = Accumulated Depreciation ÷ Annual Depreciation Expense

-+-+-+-+-+-+-

IFRS vs. US GAAP

Impairment write-downs are permitted under IFRS & US GAAP. Reversal of impairment write-downs or write-ups is only permitted under IFRS & prohibited by US GAAP.

Revaluing Impaired Assets

Impairment loss:

· reduces the carrying amount of the asset (& equity) on the balance sheet

· reduces net income on the income statement.

· does not affect CFO because it is a non-cash item

-+-+-+-+-+-+-

Revaluation of Long-lived Assets

1. Only available under IFRS. (US GAAP only allows historical cost model)

2. Long-lived assets are reported at fair market value less accumulated depreciation & impairment

3. Revaluation should be frequent enough so that reported value is close to fair value

4. Assets within can be valued using either methods based on asset classification (e.g. buildings, land, furniture, etc) but all asset in the same class should use the same method

5. Revaluation is done at asset class level to avoid selective revaluation

Impact of Revaluation on Financials

	Increase Carrying Value	Decrease Carrying Value
Assets	Increase	Decrease
Equity	Increase	Decrease
Net Income	Unchanged	Decrease
Other Comprehensive Income	Increase	Decrease

Financial Statement Disclosures of Long-lived Assets

Comparing annual capital expenditures to annual depreciation expense generally indicates:

· whether productive capacity is being maintained

· the rate at which a company is replacing its PPE relative to the rate at which PPE is being depreciated

Implications for Financial Statements & Ratios of Inventories

Summary of new* chapter in 2011 – Inventories  & Implications for Financial Statements & Ratios (longish…)

CFA Level 2 – Financial Reporting & Analysis

Study Session 5, Chapter 21 in textbook

*(I am certain I have read this material before for CFA, don’t remember if it was Level 1 or 2)

—————–

Terminology & Formula:

• Inventory Valuation Method = Cost Formula (IFRS) = Cost Flow Assumption (US GAAP)
• Cost of Sales = Cost of Goods Sold (COGS) = Beginning Inventory + Purchases – Ending Inventory
• Inventory Turnover = Activity Ratio = COGS ÷ Ending Inventory (sometime Average Inventory)
• Gross Profit Margin = Gross Profit ÷ Sales
• LIFO Reserve = FIFO Inventory Value – LIFO Inventory Value (needed to convert COGS under LIFO to FIFO)
• Days of Inventory on Hand = # of Days in Period ÷ Inventory Turnover Ratio

Converting from LIFO to FIFO

• Inventory in FIFO = Inventory in LIFO + LIFO Reserve
• COGS in FIFO = COGS in LIFO – Change in LIFO Reserve
• Total Assets in FIFO = Total Assets in LIFO + LIFO Reserve – Cash Paid for Additional Income Tax

———-

Table1: Allowed methods of Inventory Accounting under IFRS & US GAAP

Methods of Inventory Valuation	IFRS, US GAAP or Both
FIFO (first-in first-out)	Both
LIFO (last-in first-out)	US GAAP only
WAC (Weighted Average Cost)	Both
SI (Specific Identification)	Both