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Category: Essential Concepts for Level II

Essential Concept 21: Investments in Associates and Joint Ventures

An investment is considered an “associate company” when the investor has (or can exercise) significant influence, but not control, over the investee’s business activities. Significant influence is presumed with 20 – 50% ownership or voting power of the associate (investee). Significant influence may be evidenced by: Representation on the board of directors Participation in the policy-making process Material transactions between the investor and the investee Interchange of managerial personnel Technological dependency Joint ventures are ventures undertaken and controlled by two or more parties. IFRS identifies two characteristics of joint ventures as: A contractual arrangement exists between two or more venturers…. Read More

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Essential Concept 22: Business Combinations

Under IFRS, there is no distinction between business combinations. Under US GAAP, there are four types: merger, acquisition, consolidation, and variable interest entity. The acquisition method is used for business combinations. Acquisition method The major points related to the acquisition method are listed below: Identifiable tangible and intangible assets (brand names, patents etc.) and liabilities of the acquired company are measured at fair value on the date of the acquisition. Assets and liabilities that were not previously recognized by the acquiree must be recognized by the acquirer. The acquirer must recognize any contingent liability if it can be reliably measured… Read More

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Essential Concept 23: Components of Pension Costs

Total periodic pension costs (TPPC) is equal to the contributions plus change in the pension liability during the year. Total periodic pension costs = net pension liability at the end of the period – net pension liability at the start of the period + employer contribution Each period, the periodic pension cost is recognized in profit or loss (P&L) and/or in other comprehensive income (OCI). Under IFRS, the periodic pension cost is viewed as having three components: IFRS Component IFRS Recognition Service costs Recognized in P&L. Net interest income/expense Recognized in P&L as the following amount: Net pension liability or… Read More

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Essential Concept 24: Impact of Key DB Pension Assumptions

Assumption Impact of Assumption on Balance Sheet Impact of Assumption on Periodic Cost Higher discount rate. Lower obligation. Periodic pension costs will typically be lower because of lower opening obligation and lower service costs. Higher rate of compensation increase. Higher obligation. Higher service costs. Higher expected return on plan assets. No effect, because fair value of plan assets is used on balance sheet. Not applicable for IFRS. Lower periodic pension expense under US GAAP.

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Essential Concept 25: Stock Options

Compensation expense related to stock options is reported at fair value. The fair value has to be estimated using an appropriate valuation model. The fair value of stock options is sensitive to inputs and assumptions of the valuation model: Exercise price up  ?  value of option down Stock price volatility up  ?  value of option up Estimated life of each award  ?  value of option up Estimated dividend yield up  ?  value of call option down Risk free rate up  ?  value of call option up In accounting for stock options, there are several important dates, including the grant date,… Read More

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Essential Concept 26: Translation Methods

Many companies have operations in foreign countries. Subsidiaries located in foreign countries usually prepare their financial statements in the local currency. IFRS and US GAAP require parent companies to prepare consolidated financial statements in which the assets, liabilities, revenues, and expenses of both domestic and foreign subsidiaries are added to those of the parent company. To prepare consolidated financial statements, parent companies must translate the foreign currency financial statements into the parent’s presentation currency. If the foreign subsidiary’s functional currency is different from the parent’s presentation currency, the current rate method must be used. If the foreign subsidiary’s functional currency… Read More

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Essential Concept 27: Comparison of Current Rate and Temporal Methods

Current Rate Method Temporal Method Monetary assets and liabilities Current rate Current rate Non-monetary assets and liabilities measured at current value Current rate Current rate Non-monetary assets and liabilities measured at historical cost Current rate Historical rates Equity (other than retrained earnings) Historical rates Historical rates Equity (retained earnings) Beginning balance plus translated net income less dividends translated at historical rate Revenue Average rate Average rate Most expenses Average rate Average rate Expenses related to assets translated at historical exchange rate Average rate Historical rates Treatment of the translation adjustment in the parent’s consolidated financial statements Accumulated as a separate… Read More

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Essential Concept 28: The CAMELS Approach to Analyzing a Bank

The ‘CAMELS’ approach has six components which addresses the following questions: Capital adequacy – Does the bank have sufficient capital given its assets? Asset quality – What is the quality of the bank’s financial assets? Management capabilities – Is the management effective? What is its track record? Earnings – What is the level of earnings? What is the quality of earnings? Are earnings trending up or down? Liquidity: How strong is the liquidity position of the bank? What are the sources of funding? Are the sources of funding stable? Sensitivity to market risk: How sensitive are the bank’s earnings to… Read More

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Essential Concept 29: Analyzing a Property & Casualty Insurance Company

Operations: Products and Distribution Property insurance protects against loss or damage to property. Casualty insurance also called liability insurance protects against legal liability related to a third party. The premiums are collected at the start of the insurance contract. These premiums are then invested during the float period. The float period represents the time difference between receiving premiums and making insurance payouts. In order to minimize payouts, insurance companies follow a prudent underwriting process. They charge a sufficient price for the risks borne by them. They also try to diversify their risks by not concentrating on one kind of policy,… Read More

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Essential Concept 30: Analyzing a Life and Health Insurance Company

Operations: Products and Distribution There are three major sources of revenue for life and health insurance companies. Premiums Investment products and services Investment returns L&H polices are longer term compared to P&C policies. Also, L&H claims are more predictable compared to P&C claims. For these reasons, L&H companies can take more risk and therefore earn a higher return on their investments. Earnings characteristics The major expense components for L&H companies are: Benefit payments Annuity contract payments Contract surrender expenses: Some insurance policies accumulate cash value and policy holders have a right to cancel these policies before maturity. If cancelled, the… Read More

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