育

Financial Reporting & Analysis

教
顿
高
Instructor: Wen

1
Brief Introduction
Topic weights for CFA level II:
Study Session 1 Ethics & Professional Standards 10 -15%
Study Session 2-3
Study Session 4
Quantitative Methods
Economics
育
5 -10%
5 -10%
Study Session 5-6
Study Session 7-8 Corporate Finance
教
Financial Reporting and Analysis 10 -15%
5 -10%
Study Session 9-11
Study Session 12-13
顿
Equity Investment
Fixed Income
10 -15%
10 -15%
Study Session 14
Study Session 15
Study Session 16-17 高 Derivatives
Alternative Investments
Portfolio Management
5 -10%
5 -10%
5 -15%
Weights : 100%

2
Brief Introduction

Contents:

育
Ø Study Session 1: Financial Reporting and Analysis (1)

üReading 1: Intercorporate Investments (☆☆☆)

üReading 2: Employee Compensation (☆☆☆)

教
顿
üReading 3: Multinational Operations (☆☆☆)

üReading 4: Analysis of Financial Institutions (☆☆)

高
3
Brief Introduction

Contents:

育
Ø Study Session 2: Financial Reporting and Analysis (2)

üReading 5: Evaluating Quality of Financial Reports(☆☆)

教
üReading 6: Integration of Financial Statement Analysis Techniques (☆☆)

顿
高
4
Intercorporate Investments育
教
顿
高
Instructor: Wen

5
Intercorporate Investments

Summary of Accounting Treatments for Investments

育
Financial Associates Business Joint
Assets Combination Ventures

教
Degree of No Significant Control Shared
influence Significant influence control
influence
percentage
of interest
< 20% 20% - 50%

顿
> 50% Varies

高
Term of N/A Associate Subsidiary N/A
investee
Accounting ü AMC Equity Acquisition Equity
treatment ü FVOCI method method method
ü FVPL
6
 育
Investment in Financial Assets
教
顿
高
Instructor: Wen

7
Investment in Financial Assets

Two criteria:

育
Ø Business model test

Ø Cash flow characteristic test

Three different categories of measurement:

教
Ø Amortized cost (AMC)

顿
高
Ø Fair value through other comprehensive income (FVOCI)

Ø Fair value through profit or loss (FVPL)

8
Investment in Financial Assets

Two criteria:

育
Ø A cash flow characteristic test: The contractual cash flows
are solely payments of principal and interest on principal.

教
Ø A business model test: The financial assets are being held

顿
to collect contractual cash flows.

高
9
Investment in Financial Assets

Classification model

育
Debt Equity

教
Yes
Designated at FVPL? Yes
Held for trading?

顿
No
No
Business model test and No

高
cash flow characteristic Yes
test are satisfied? Designated at FVOCI?

Yes No

Amortized cost or FVOCI FVPL FVOCI

10
Investment in Financial Assets

Three different categories of measurement:

育
AMC FVPL FVOCI

Measurement Amortized Cost Fair Value Fair Value

Realized G/L Record in I/S Record in I/S

教
Capital gain
record in R/E

顿
Div or Interest
record in I/S

高
Unrealized G/L Ignore Record in I/S Record in OCI

11
Investment in Financial Assets

Reclassification

育
Ø Under IFRS 9, reclassification of equity instruments is
not permitted.

教
Ø Reclassification of debt instruments is only permitted if

顿
business model has changed.

高
12
Investment in Financial Assets

Impairment

育
Ø From “incurred loss” to an “expected loss” model.

Disclosure

教
Ø Both IFRS & US GAAP require disclosure of fair value of each class
of investment in finance assets.

顿
高
13
Investment in Associates 育
教
顿
高
Instructor: Wen

14
Investment in Associates

Definition : Significant Influence (but not control):

育
Ø Representation on the board of directors

Ø Participation in the policy-making process

教
Ø Material transactions between the investor and the investee

顿
Ø Interchange of managerial personnel

Ø Technological dependency

高
15
Investment in Associates

Equity method of accounting

育
Ø Initially record on investor’s B/S at cost.

Ø In Subsequent periods, the carrying amount of the

教
investment is adjusted to recognize the investor’s

顿
proportionate share of the investee’s operating results.

Ø ‘One-line consolidation’

高
16
Investment in Associates

Equity method of accounting

育
Ø Goodwill: the difference between the acquisition value
and the fair value of the target’s identifiable net assets.

教
Ø Goodwill is included in the carrying amount of the

顿
investment, because investment is reported as a single
line item on the investor’s balance sheet.

高
17
Investment in Associates

Equity method of accounting

育
Ø Amortization of excess purchase price

üThe excess purchase price allocated to the assets

教
and liabilities is accounted for in a manner that is

顿
consistent with the accounting treatment for the
specific asset or liability to which it is assigned.

高
18
Investment in Associates

Equity method of accounting

育
Ø Transactions with Associates

üUpstream (associate to investor)

üDownstream (investor to associate)

教
顿
高
19
Investment in Associates

Equity method of accounting

育
Ø Transactions with Associates

üprofits from such transactions cannot be realized until

教
confirmed through use or sale to third parties.

顿
üthe investor company’s share of any unrealized profit
must be deferred by reducing the amount recorded

高
under the equity method.

20
Investment in Associates

Equity method of accounting

育
Ø ‘One-line consolidation’ in B/S

Ø ‘One-line consolidation’ in I/S ------ Share investee’s profit

教
Ø Dividends reduce carrying amount directly

顿
Ø Equity Investment 0

+ Investee’s Net Income %

- Dividends received %

= Equity Investment 1
高
21
Investment in Associates

Impairment of equity investment

育
IFRS US GAAP

Impairment carrying amount of investment > carrying amount of

教
Test recoverable amount investment > fair value
Impairment
recognized in I/S

顿
Loss
prohibit the reversal of impairment losses even if the fair value
Reversal

高
later increases

22
Business Combination 育
教
顿
高
Instructor: Wen

23
Business Combination

Acquisition method

Consolidated B/S

育
教
Assets Liabilities
ü 母 BV Asset ü 母 BV Liability
ü – Purchase price
ü + Goodwill (Full v. Partial)
顿
ü + 100% 子 FV Liability

高
Equity
ü + 100% 子 FV Asset
ü 母 BV Equity
ü Minority Interest (Full v. Partial)

24
Business Combination

Acquisition method (initial record ---- goodwill)

育
Ø Recognition and measurement of goodwill

Ø Full goodwill = Fair value if purchase 100% equity – Fair value of

identifiable net assets of the subsidiary
教
顿
Ø Partial goodwill = Fair value of consideration given - Fair value of
net identifiable assets of the subsidiary×Owned%

高
Ø US GAAP allows full goodwill method only

25
Business Combination

Acquisition method (subsequent record)

育
Ø Consolidated Income Statement

üLine by line 100% consolidated

üMinus minority Interest in consolidated I/S

教
顿
Parent’s I/S Subsidiary’s I/S Consolidated I/S
Revenue x1 Revenue y1 Revenue x1 + y1

高
- Cost x2 - Cost y2 - Cost x2 + y2
- Interest x3 - Interest y3 - Interest x3 + y3
- Tax x4 - Tax y4 - Tax x4 + y4
- MI - y5 * not own %
Net Income x5 Net Income y5 Net Income Consolidated NI

26
Business Combination

Acquisition method (subsequent record)

育
Ø Impairment
IFRS US GAAP

教
Object Cash-generating units Reporting units
One-step approach Two-step approach
Methods

顿
Recoverable amount Fair Value
Impairment Reduce to recoverable amount Calculate implied goodwill

高
Loss Recognized in I/S and cannot be reversed

27
Business Combination

Other issues ------ SPE & VIE

育
Ø Special purpose entities (SPEs) and variable interest entities
(VIEs) are required to be consolidated by the entity which is

教
expected to absorb the majority of the expected losses or

顿
receive the majority of expected residual benefits.

高
28
Business Combination

Acquisition vs Equity Method

育
Ø Reported financial results from different accounting methods:

教
Financial Reports & Ratios Equity Method Acquisition Method

Assets & Liability Lower Higher

Equity

Revenue & Expenses

Lower

Lower
顿 Higher

Higher

NI

Net profit margin

ROE & ROA

高
The Same

Higher

Higher
The Same

Lower

Lower

29
Employee Compensation
育
教
顿
高
Instructor: Wen

30
Funded Status

Offset disclosure (net reporting)

育
Ø If the plan assets exceed the pension obligation, the plan is
said to be overfunded.

教
Ø If the pension obligation exceeds the plan assets, the plan

顿
is underfunded.
Employer’s B/S Employer’s B/S

Assets
ü F.S. 高 Liabilities
ü F.S.

31
Funded Status

Asset ceiling

育
Ø when a company has a surplus in a defined benefit plan,
the amount of reported asset cannot be larger than the
asset ceiling.

教
顿
Ø Asset ceiling is also known as the PV of future economic
benefits, such as refunds from the plan or reductions of
future contributions.

高
32
Balance Sheet Presentation

Plan assets at the beginning of the year PBO at the beginning of the year

育
+ Employer contribution + Current service cost
+ Actual return + Interest cost
- Benefit paid to employee + Past service cost
= Plan assets at the end of year

教
+/- Actuarial losses/gains
- Benefit paid to employee

顿 = PBO at the end of the year

高
Difference is funded status of the plan 。。。。。。。。

33
Periodic Pension Cost
育
教
顿
高
Instructor: Wen

34
Periodic Pension Cost

Definition of total periodic pension cost (TPPC)

育
Ø The periodic pension cost is recognized in profit or loss (P&L)
or in other comprehensive income (OCI).

Ø TPPC = PPC in I/S + PPC in OCI

教
顿
Ø Funded Status 0 + Employer contribution – TPPC = Funded Status 1

高
35
Periodic Pension Cost
Difference under US GAAP and IFRS
PPC in I/S

育
US GAAP IFRS

Rev – Current Service Cost Rev – Current Service Cost

教
(Cost) – Interest Cost (Cost) – Past Service Cost
NI + Expected Return NI + Expected Return

顿
– Amortized P.S.C – Interest Cost
+ Amortized Actuarial G/L

高
PPC in OCI
US GAAP IFRS

– Unamortized P.S.C. + Remeasurement : Actuarial G/L

+ Unamortized Actuarial G/L

36
Periodic Pension Cost -- US GAAP

Amortization – corridor approach

育
Ø If the beginning balance of actuarial gain/loss exceed 10%
of the greater of the beginning PBO or Plan Assets, the

教
excess amount over the “corridor” is amortized in I/S over

顿
the remaining service life of the employees.

高
37
Periodic Pension Cost -- US GAAP

Amortization – past service cost

育
Ø Past service costs are amortized to income statement over
the average service lives of the employees.

教
顿
高
38
Example of Periodic Pension Cost
The following information is about the DB pension plan of a company:
Employer contributions $1,200

育
Current service costs $1,850
Past service costs $120

教
Beginning PBO $38,750
Ending PBO $43,619

顿
Increase in PBO due to changes in actuarial assumption $628
Beginning plan assets $28,322
Ending plan assets $30,682

高
Actual return on plan assets $1,795
Benefits paid $635
Unamortized actuarial losses (US GAAP only) $3,150
Expected rate of return on plan assets 6%
Discount rate used in estimating PBO 7.5%
39
Example of Periodic Pension Cost

Calculate:

育
A. Total periodic pension cost.

B. Periodic pension cost reported in I/S under US GAAP

(ignore amortization of past service cost)
教
顿
C. Periodic pension cost in reported in I/S under IFRS.

高
D. Periodic pension cost reported in OCI under US GAAP

E. Periodic pension cost reported in OCI under IFRS.

40
Answer for Question A

A : Total Periodic Pension Cost

育
Ø Funded Status 0 + Employer contribution – TPPC = Funded Status 1
TPPC = $1,200 – [ (-$12,937) – (-$10,428) ] = $3,709

教
顿
高
41
Answer for Question B

B : Periodic pension cost in I/S under US GAAP

育
Ø Beginning PBO > Beginning Plan Asset, we take 10% of beginning
PBO as corridor = $3,875; Since unamortized actuarial losses

教
($3,150) do not exceed $3,875, no amortization is necessary.

顿
Ø PPC in I/S = Current service cost + Interest cost – Expected return
on plan assets = $1,850 + $2,906 - $1,699 = $3,057

高
* Expected return = Expected rate of return x Beginning plan assets = 6% x $28,322 = $1,699

42
Answer for Question C

C : Periodic pension cost in I/S under IFRS

育
Ø PPC in I/S = Current service cost + Past service cost + Net interest cost =
$1,850 + $120 + $782 = $2,752

教
顿
* Net interest cost = Discount rate x Beginning funded status = 7.5% x ($10,428) = - $782

高
43
Answer for Question D & E

D : Periodic pension cost in OCI under US GAAP

育
Ø PPC in OCI = TPPC – PPC in I/S = $3,709 – $3,057 = $652

E : Periodic pension cost in OCI under IFRS

教
Ø PPC in OCI = TPPC – PPC in I/S = $3,709 – $2,752 = $957

顿
高
44
 育
Analysis of Pension Accounting

教
顿
高
Instructor: Wen

45
Effect of Changing Pension Assumption

Three assumptions used in its pension calculations:

育
Ø Discount rate : used to compute PV of the benefit
obligation and the current service cost. Based on high

教
quality corporate fixed income investments with a

顿
maturity profile similar to the future obligation.

Ø Rate of compensation growth : affect both PBO and

pension expense.

高
Ø Expected return on plan asset (US GAAP) : assumed
long-term rate of return on plan’s investments.

46
Effect of Changing Pension Assumption

Increasing the discount rate

育
Ø Reduce PBO; improve the Funded Status.

Ø Lower Pension expense because of lower service cost.

教
Ø Reduce interest cost unless the plan is mature.

顿
高
47
Effect of Changing Pension Assumption

Decreasing the compensation growth rate

育
Ø Reduce PBO; improve the Funded Status.

Ø Reduce current service cost and lower interest cost.

Ø Decrease pension expense.

教
顿
高
48
Effect of Changing Pension Assumption

Increasing expected return on plan assets (US GAAP)

育
Ø Reduce periodic pension expense in I/S.

Ø TPPC unchanged.

教
Ø Not affect the benefit obligation or the Funded Status.

顿
高
49
Effect of Changing Pension Assumption

Conclusion

育
Effect on Increase Decrease Increase Expected
Discount Compensation Rate of Return

教
Rate Growth rate
B/S Liability Decrease Decrease No Effect

顿
TPPC Decrease Decrease No Effect
PPC in I/S Decrease Decrease Decrease (US GAAP)

高
50
Other Post-employment Benefits

Accounting for OPB

育
Ø OPB can be will as an extension of DB Plan.

Ø The assumption of OPB’s healthcare inflation rate is similar

教
as compensation growth rate. This rate is also known as

顿
the ultimate healthcare trend rate.

高
51
Other Post-employment Benefits

Accounting for OPB

育
Ø Firms can reduce the post-employment benefit obligation
and periodic expense by:

教
üDecreasing the near term healthcare inflation rate.

顿
üDecreasing the ultimate healthcare trend rate.

üReducing the time need to reach the ultimate healthcare

trend rate.
高
52
Gross vs. Net Pension Assets/Liabilities

Disclosure

育
Ø Amounts Disclosed in the B/S are net amounts.
Adjustments to incorporate gross amounts would change
certain financial ratios.

教
顿
Ø Analysts can adjust a company’s assets and liabilities for
the gross amount.

高
Ø An argument for making such adjustments is that they
reflect the underlying economic liabilities and assets of a
company.

53
Classification of Periodic Pension Costs in I/S

Analyst reclassification

育
Ø Analyst can reclassify the report by (ignores any amortization):

ü1. Add back the PPC in I/S.

教
ü2. Subtracting only service cost in determining operating

顿
income and add Interest cost to the firm’s interest expense.

ü3. Add actual return to non-operating income.

高
54
Classification of Periodic Pension Costs in I/S

Reclassification example

育
Ø Use the following information to reclassify the components of
periodic pension cost between operating and non-operating items :

I/S PPC in I/S

教
顿
Operating profit $145,000 Current service cost ($7,000)
Other income $2,000 Interest cost ($5,000)

高
Interest expense ($12,000) Expected return $8,000
Earnings before tax $135,000 Total ($4,000)
*Actual return on plan asset = $9,500

55
Example of Reclassifying PPC

Answer :

育
I/S Step 1 Step 2 Step 3
Operating profit $145,000 + $4,000 – $7,000

教
Other income $2,000 + $9,500
Interest expense ($12,000) – $5,000

顿
Earnings before tax $135,000

Adjusted I/S
Operating profit
Other income
Interest expense
$142,000
$11,500
($17,000)
Earnings before tax $136,500
高
56
Analyst’s View on Cash Flow Adjustment

Analysis of cash flow

育
Ø Over-contribution : contribution > TPPC : Repayment

üCFO adjustment = CFO + (Contribution - TPPC) * (1 - t)

教
üCFF adjustment = CFF - (Contribution - TPPC) * (1 - t)

顿
Ø Under-contribution: contribution < TPPC : Borrowing

üCFO adjustment = CFO - (TPPC - Contribution) * (1 - t)

高
üCFF adjustment = CFF + (TPPC - Contribution) * (1 - t)

57
Share-based Compensation
育
教
顿
高
Instructor: Wen

58
Share-based Compensation

Share-based compensation is intended to align employees’

育
interests with those of the shareholders and is typically a
form of deferred compensation.
Ø Stock options
Equity settled
教
顿
Ø Stock grants

Ø Stock appreciation rights

Ø Phantom shares
高 Cash settled

59
Share-based Compensation

Stock option

育
Grant date Vesting date

Service period
Recognize the compensation expense
教
The first date the
over the service period

顿 employee can
actually exercise

高
the option
Fair value of stock option at the grant
date is used to determine the
compensation expense over service
period.
60
Share-based Compensation

Stock option : Sensitivity factor

育
Changes Value of Call Influence on NI

Volatility ( Vega ) increase increase decrease

Risk free Rate ( Rf ) increase increase

教 decrease

Time to Expiration ( Theta ) increase

顿
increase decrease

高
Dividends decrease increase decrease

61
Multinational Operations
育
教
顿
高
Instructor: Wen

62
 育
Foreign Currency Transaction
教
顿
高
Instructor: Wen

63
Multinational Operations

Influence of foreign currency accounting

育
Ø Foreign currency can affect a multinational firm's financial
statements in two ways:

üForeign currency transaction

教
顿
üForeign currency translation

高
64
Multinational Operations

Foreign currency transactions

育
Ø Foreign currency transactions are measured in the presentation
(reporting) currency at the spot rate on the transaction date.

教
Ø Foreign currency risk arises when the transaction date and the

顿
payment date differ.

Ø Differences arising on the transactions are recognized in the I/S.

高
65
Foreign Currency Transactions

Impact due to changes in foreign currency exchange rate

育
Transactions Types of Exposure Foreign Currency

Appreciation Depreciation
Export Sales Asset ( A/R ) Gain
教 Loss

顿
Import Purchase Liability ( A/P ) Loss Gain

高
66
 育
Foreign Currency Translation

教
顿
高
Instructor: Wen

67
Translation Method

Scenarios

育
Parent’s Financial Statement Parent’s Financial Statement

Consolidated Consolidated

Parent’s Reporting Currency

教
Parent’s Reporting Currency

顿
Translated : Current rate method

Subsidiary’s Functional Currency Subsidiary’s Functional Currency

Subsidiary’s Local Currency

High degree autonomy

高 Translated : Temporal method
Subsidiary’s Local Currency

68
Current Rate Method
Step 1 : Calculate NI in reporting currency
Rev

育
COGS
SG&A
Depreciation × Average Rate

教
Interest
Tax
NI × Average Rate

顿
Step 3 : Calculate R/E in reporting currency
R/E 0 + NI - Div. Declared = R/E 1

高
Step 2 : Calculate Equity in reporting currency

Assets Liabilities × Current Rate

×
Current Equity
× Capital × Historical Rate
Rate R/E 1 from step 3
Current
OCI : CTA Step 4 : Calculate CTA in OCI
Rate
69
Temporal Method
Step 1 : Calculate R/E in functional currency
Cash × Current rate Payables × Current rate

A/R × Current rate
Inv × Historical rate
PP&E × Historical rate
育
Unearned rev. × Historical rate
Total Liabilities × Mix rate
Capital × Historical rate

教
Intangible × Historical rate
Translated Assets – Translated Liabilities – Translated Capital = R/E 1
Total Assets × Mix rate
Step 2 : Calculate NI in functional currency

顿
R/E 0 + NI - Div. Declared = R/E 1

Step 3 : Calculate Remeasurement G/L in functional currency

Rev × Average rate

高
COGS × Historical rate
SG&A × Average rate
Depreciation × Historical rate
Interest × Average rate
Tax × Average rate
Remeasurement G/L
NI from step 2
70
Balance Sheet Exposure to Translation

Balance sheet exposure

育
Ø Only items translated or re-measured using current exchange
rate will have exchange rate exposure.

Ø C-method : B/S exposure = asset - liability

教
顿
Ø T-method : B/S exposure = monetary asset – monetary liability

高
Scenario Balance Sheet Subsidiary’s local currency
Exposure (usually) Strengthens Weakens
C-method Net asset Translation gain Translation loss
T-method Monetary liability Translation loss Translation gain

71
Hyperinflationary Economy育
教
顿
高
Instructor: Wen

72
Translation in Hyperinflationary Economy

Highly inflationary economy :

育
Ø Cumulative three-year inflation rate exceeds 100%.

Ø Average of approximately 26% per year.

教
If subsidiary is operating in a hyperinflationary environment

顿
Ø US GAAP : the temporal method is used.

高
Ø IFRS : restated for inflation and then translated using the
current exchange rate.

73
Translation in Hyperinflationary Economy
2014 2015
Cash 5,000 8,000

育
Inventory 25,000 25,000
Total assets 30,000 33,000
Accounts payable 20,000 20,000

教
Common stock 10,000 10,000
Retained earnings 0 3,000

顿
Liabilities and equity 30,000 33,000
Revenue 15,000
Expenses (12,000)

高
Net income 3,000

GPI* (2014/12/31) = 100 Current exchange rate = $0.5/LC

GPI* (2015/12/31) = 150
Average GPI* for 2015 = 125
*GPI is the general price index.

74
Translation in Hyperinflationary Economy

In LC 2015 Adjustment Inflation Exch. In Reporting

Factor Adjusted Rate Currency

育
Cash 8,000 8,000 0.5 4,000
Inventory 25,000 (1+50%) 37,500 0.5 18,750

教
Total assets 33,000 45,500 22,750
Accounts payable 20,000 20,000 0.5 10,000
Common stock 10,000 (1+50%) 15,000 0.5 7,500

顿
Retained earnings 3,000 10,500 0.5 5,250
Liabilities and equity 33,000 45,500 22,750

高
Revenue 15,000 (1+20%) 18,000 0.5 9,000
Expenses (12,000) (1+20%) (14,400) 0.5 (7,200)
Net purchasing power 6,900 0.5 3,450
gain / loss
Net income 3,000 10,500 5,250

75
Analysis of Accounting 育
教
顿
高
Instructor: Wen

76
Financial Ratios under Current Rate Method

Pure ratios are unaffected when translated by C-method.

育
Mixed ratios will be different when translated by C-method.
Subsidiary’s Local Currency

Pure ratio
Strengthens
The same
Weakens
The same
教
Mixed ratio Lower

顿 Higher

高
77
Financial Ratios under Current Rate & Temporal Method

Local Currency Depreciation C-Method T-Method

Quick Ratio The same The same

育
教
Current Ratio Lower Higher
Receivables Turnover The same The same

Fixed Assets Turnover

顿
Higher Lower

高
Interest Coverage Ratio Higher Lower
Net Profit Margin, ROA, ROE Uncertain Uncertain

78
Impacts on Effective Tax Rate

2010 2011

育
Domestic statutory tax rate 25% 25.5%
Effect of tax rates in foreign jurisdictions 3.5% 1.6%

教
Effect of tax incentives and exempt income -6.0% -8.2%
Effect of non-deductible expenses 3.2% 4%

顿
Effect of changes in tax rate 0.5% 0.1%
Effective tax rate 26.2% 23.0%

高
79
 育
Analysis of Financial Institutions

教
顿
高
Instructor: Wen

80
Financial Regulations

Basel III

育
Important Highlights
Ø Minimum capital requirement

Ø Minimum liquidity requirement

教
Ø Stable funding requirement

顿
高
81
Analyzing a Bank 育
教
顿
高
Instructor: Wen

82
The CAMELS Approach

Capital adequacy

育
Asset quality

教
Management capabilities

Earnings sufficiency

Liquidity position
顿
高
Sensitivity to market risk

83
The CAMELS Approach

Capital adequacy

育
Ø Capital is classified into hierarchical tiers.
Capital Tier CET 1 Capital Total Tier 1 Capital Total Capital

教
Minimum capital
4.5% 6% 8%
ratio requirement

顿
Subordinated,
Common stock, Retained CET1 + Noncumulative
Contents minimum five-year
earnings, AOCI, others preferred stocks
maturity

高
84
The CAMELS Approach

Asset quality

育
Ø From the perspective of the composition of a bank’s assets. What
proportion of total assets was invested in highly liquid assets?

教
Ø From the perspective of credit quality. Two dimensions in

顿
analyzing asset quality for loans:

üCreditworthiness of the borrowers.

高
üAdequacy of adjustments for expected loan losses.

üAllowance for loan losses and provision for loan losses.

üPerforming assets & non-performing assets.

85
The CAMELS Approach

Management capabilities

育
Ø Effective management: successfully identifying and exploiting
profit opportunities simultaneously managing risk

教
顿
高
86
The CAMELS Approach

Earnings

育
Ø Composition :

Ø net interest income

Ø service income
教
顿
Ø trading income

高
87
The CAMELS Approach

Liquidity position—LCR

育
Ø Liquidity Coverage Ratio (LCR) is expressed as the
minimum percentage of a bank’s expected cash outflows
that must be held in highly liquid assets.

教
顿
Ø Expected cash outflows (the denominator) are the bank’s
anticipated one-month liquidity needs in a stress scenario.

高
Ø Highly liquid assets (the numerator)include only those that
are easily convertible into cash.

Ø Minimum: 100%.
88
The CAMELS Approach

Liquidity position—NSFR

育
Ø Net Stable Funding Ratio is expressed as the minimum
percentage of a bank’s required stable funding that must be
sourced from available stable funding.

教
顿
Ø The ratio relates the liquidity needs of the financial institution’s
assets to the liquidity provided by the funding sources.

Ø Minimum: 100%.
高
89
The CAMELS Approach

Sensitivity to market risk

育
Ø Exposures to market movements:

üMismatches in the maturity of banks’ loans and deposits

üRepricing frequency
教
顿
üReference rates

üCurrency

Ø Typical Indicator—VaR
高
90
 育
Analyzing a Insurance Company

教
顿
高
Instructor: Wen

91
Insurance Companies

Types P&C L&H

Contract duration Short term Long term

育
教
Claims are more Claims are more
Variability of claims
variable and lumpier predictable
Provide benefit upon

顿
Business profile Protect against loss or
death and a savings
damage to property
vehicle

高
Investment returns Conservative Seek higher returns

Liquidity Higher degree

Lower capital
Capitalization
requirements
92
Insurance Companies

Analysis of P&C companies’ profitability

育
Earnings characteristics
Loss and loss ü Measure quality of underwriting activities.

教
adjustment ü The lower the ratio the higher quality.
expense ratio !"## $%&$'#$(!"## )*+.$%&$'#$
ü
Ratio (1) -$. &/$0120# $)/'$*

顿
ü Measure the efficiency of acquiring and managing
Underwriting underwriting business.
expense ratio ü The lower the ratio the higher efficiency.

高
Ratio (2) 3'*$/4/1.1'5 $%&$'#$
ü
-$. &/$0120# 4/1..$'
ü Measure the overall efficiency of underwriting operation.
Combined
ü (1) + (2)
ratio
ü < 100% à Efficiency

93
Evaluating Quality of
育
Financial Reports
教
顿
高
Instructor: Wen

94
Evaluating Quality of Financial Reports

Quantitative tools

Beneish Model
Assess the probability of
Altman Model

育
教
Assess the probability of bankruptcy.
manipulation.
M-score Z-score

-1.78 Higher

顿
High 1.81 3 Low

高
M-score
Uncertain
Z-score

95
Evaluating Quality of Financial Reports

Sustainable earnings

育
Ø Sustainable earnings are earnings that are expected to
recur in the future.

Ø Earningst+1 = α + β1 Earningst + ε
教
顿
üA higher value of β1 indicates higher persistence of
earnings

高
96
Evaluating Quality of Financial Reports

Sustainable earnings

育
Ø Earningst+1 = α + β1 Cash flowt + β2 Accrualst + ε

üEarnings can be viewed as being composed of a cash

component and an accruals component
教
顿
üIf the coefficient on cash flow (β1) has been shown to
be higher than the coefficient on accruals (β2),

高
indicating that the cash flow component of earnings is
more persistent

97
Evaluating Quality of Financial Reports

Sustainable earnings

育
Ø Organic growth in sales that is achieved by making
investments internally, excluding growth achieved

教
through mergers and acquisitions or currency effect.

顿
高
98
 育
Integration of Financial Statement
教
Analysis Techniques

顿
高
Instructor: Wen

99
Integration of Financial Statement Analysis Techniques

Earnings sources and performance

育
Ø Return on equity (ROE) can be decomposed using the
extended DuPont equation

Ø Adjustment
教
顿
üRemove equity method income and the investment
asset from the extended DuPont equation.

ROE =
NI EBT
× ×
EBIT
×高 Revenue
×
Average assets
EBT EBIT Revenue Average assets Average equity

100
Integration of Financial Statement Analysis Techniques

Earnings sources and performance

育
Ø Necessary modifications:

üSubtract income from associates from net income

教
üSubtract the amount of investment in associates from

顿
total assets

高
101
Integration of Financial Statement Analysis Techniques

Capital structure

育
Ø If ratio of proportional capex to proportional assets is
greater than 1, Firm is growing the segment by allocating
more resources to the segment.

教
顿
Ø If ratio of proportional capex to proportional assets is less
than 1, Firm is allocating less resources to the segment.

高
102
Integration of Financial Statement Analysis Techniques

Earnings quality

育
Ø Earnings can be disaggregated into cash flow and accruals using:
üBalance sheet approach
üCash flow statement approach
教
顿
Ø Measure earnings quality using the ratio of accruals to average
net operating assets, the lower the ratio, the higher the
earnings quality.
高
103
Integration of Financial Statement Analysis Techniques

Accruals ratio

育
Ø Balance sheet approach

üAggregate AccrualsBS = NOA1 – NOA0

教
üAccruals ratioBS = (NOA1 – NOA0) / [(NOA1 + NOA0)*1/2]

顿
üNet operating asset is the difference between operating
assets and operating liabilities

高
104
Integration of Financial Statement Analysis Techniques

Accruals ratio

育
Ø Cash flow statement approach

üAccrualsCF = NI – CFO – CFI

教
üAccruals ratioCF = (NI – CFO - CFI) / [(NOA1 + NOA0)*1/2]

顿
高
105
Integration of Financial Statement Analysis Techniques

LIFO reserve

育
Ø Inventory FIFO – Inventory LIFO = LIFO Reserve

Ø COGS LIFO – COGS FIFO = ΔLIFO Reserve

Ø NIFIFO – NILIFO = Δ LIFO Reserve×(1 − t)

教
顿
高
106
Integration of Financial Statement Analysis Techniques

US-GAAP - CFO

育
Inflows Outflows
Cash collected from customers Cash paid to employees and suppliers

教
Sale proceeds from trading securities Acquisition of trading securities
Interest received Interest paid

顿
Dividend received Taxes paid
Cash paid for other expense

高
107
Integration of Financial Statement Analysis Techniques

Ratios

育
Ø Activity ratios

Ø Liquidity ratios

Ø Solvency ratios
教
顿
Ø Profitability ratios

高
108