Canadian Interest Rates & Fixed Mortgage Rates

Fixed mortgage rates are no longer “historically low” … 1, 3 & 5 year fixed rates increased by 15, 20 & 25 basis points in the 2nd week of Feb 2011… this is the beginning of a trend that might pick up pace given that the Canadian economy (& global economy) is performing better than forecast.

BOC is scheduled to announce interest rate decision tomorrow and market expects no change to the BOC rate, currently at 1% …

The bond markets expect the BOC rates to rise 25 basis points in the next 3 months… look at the steepening yield curve.

Pouring cold water on ‘improved’ housing activity

Canadian real-estate has received more than its fair share of coverage in main stream media lately…

The quacks at CREA say housing activity  “improved” …

Seasonally adjusted national home sales activity rose 4.5 per cent in January 2011 compared to the previous month, reaching the highest level since April 2010. Led by Vancouver and Toronto…

…

Actual (not seasonally adjusted) national sales activity via the Multiple Listing Service^® (MLS^®) Systems of Canadian real estate Boards came in 6.6 per cent below levels in January 2010. This was the smallest year-over-year decline since May 2010.

…

Now if it hadn’t been for Flaherty’s tinkering with mortgage rules and pulling demand forward and creating a buying panic, sales activity would be lower…agree? I will explain why…Lets look at GTA since it accounts for the biggest share of Canadian housing activity and it led the “improvement”…

The Toronto Real Estate Board publishes mid-month &  monthly sales figures;

Mid-month figures for January 2011

January 19, 2011 — Greater Toronto REALTORS® reported 1,563 sales during the first two weeks of January 2011 – an 11 per cent decrease compared to the first two weeks of January 2010. See details.

Until 15-Jan-2011, sales in GTA were 11% lower than Jan 2010… then on 17-Jan-2011… The federal government acts prudently (in my opinion) and announces new mortgage lending rules… How did those changes affect sales for the rest of Jan 2011?

Monthly figures for January 2011

February 4, 2011 — Greater Toronto REALTORS® reported 4,337 transactions through the TorontoMLS® system in January 2011. This result was 13 per cent lower than the record result reported in January 2010. See details.

So even after taking some heat of the housing market and creating an apparent demand pull, January 2011 sales were 13% lower than Jan 2010… Perhaps 2010 was a record so maybe not a good year to compare?…  Sales were 3.5% lower compared to the average sales from 2006-2010… even when including the paltry 2670 units in 2009!! (it is a clear outlier)

Moving on to Feb…

February 17, 2011 — Greater Toronto REALTORS® reported 3,084 sales during the first two weeks of February 2011 – a 13 per cent decrease compared to the first two weeks of February 2010. See details.

One month since the announcement and sales are lower than last year… if there was no government intervention, logic dictates that sales would be even higher because people (first time home buyers) would rush to buy a home on more favourable terms.

Admittedly though, compared to average Feb sales between 2006-2010, mid-month Feb 2011 sales were 6.2% higher.

via Toronto Real Estate Board.

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…

Why I blog and blogging goals for 2011

I started this blog last spring because I couldn’t find data/charts on Canadian economic accounts and financial markets… I was hoping to ‘fill’ a gap. That is what I think now but that could be biased based on my blogging experience since…

luckily I did describe the reason for blogging here:

… my goal with this blog is to try and answer some of my questions on personal finance and broadly on capital markets while I start building my retirement portfolio… i find it easier to learn visually – pictures, charts, videos, etc – instead of reading tons of material…whenever possible I will simplify lear

…

here are some of my questions on personal finance

• are we paying too much for banking services in Canada?
• canadian housing scene?
• why don’t consumer rates move in tandem with bank of canada rate?

The above is the perfect example of a false memory or consistency bias:

confusion of imagination with memory, or the confusion of true memories with false memories.

…

incorrectly remembering one’s past attitudes and behavior as resembling present attitudes and behavior

Anyways, I want to blog more and use blogging  as a tool towards completing CFA… I write the Level 2 exam in June so I will be posting regularly till then and then hopefully in Fall I will start writing about level 3! … and in the meantime try to apply what I have learnt with at least one post a week.

Why do I like blogging?

Because it

1. is fun!
2. helps clear thoughts
3. invokes questions resulting in deeper analysis
4. enhances writing skills
5. creates a permanent record and eliminates memory biases (like above)

Here are some more reasons from blogs I frequent:

The Big Picture

Abnormal Returns

It is not easy but I’m promising to make use of The DailyPost, and the community of other bloggers with similar goals, to help me along the way, including asking for help when I need it and encouraging others when I can.

If you already read my blog, I hope you’ll encourage me with comments and likes, and good will along the way 🙂

Update (30-Mar-2011): This post by Eric Jackson on 7 reason why any investor should write is also pretty neat.

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

Emerging Markets – Can’t get past the (inflation) hump?

Where are emerging markets going? Do the emerging market central banks and Treasurers have the balls to stop inflation or they can’t live without the growth on stereoids?

The MSCI iShares Emerging Markets index has failed twice to break the 2008 highs… are we heading lower to test May 2010 levels or break the 2008 highs?

Will Canadian real-estate slow down after March 18?

I have spoken to a couple mortgage brokers and agents in the last week and:

Mortgage brokers are expecting reduced liquidity after March 18 which will affect first-time home buyers and pull demand forward…like last year’s implementation of HST.

There has been little in mainstream media regarding the proportion of mortgages with 35 year amortization…

RBC (via CMT)

30% of new mortgages were 35 year amortizations last year vs 8% of existing mortgages.

via CMT

As of November, 42% of new purchase financing over the prior 12 months had amortizations over 25 years. Two years ago it was 47%.

The bulk of those were 35-year amz but I don’t have the exact ratio or the breakdown by home price.

From a real-estate agent who works with 2 mortgage brokers

“90% of our deals were high ratio, and approximately 70% were both high ratio and 35yr amortization.”

Via another broker I spoke to on Saturday

95% of her first-time home buyers have chosen 35-yr amoritzations

Will this round of tightening be enough to slow down the real-estate market in Canada? Or is something radical like prohibiting real-estate agents from fostering false confidence (prices always go up), using scare tactics (not many homes in the market), creating bidding wars (this is the worst, because there is no transparency,  i would like to dedicate a post to this at some point)

open discussion… your thoughts?

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…