1 Question 1 (1) ADJUST: Taking into account the time-series of quarterly effective tax rates (above), adjust the “Income from Continuing Operations” for: (a) 4Q2019 (1 mark) Take an effective tax rate from chart or 2018 comparative x Income from Continuing Operations before Income Tax (3,994m) (b) Explain any assumptions or reasoning you used in your choice (or use) of effective tax rate, above. (1 mark) E.g. I choose 25% because it seems to be stable around the average of 25% up to Sep- 12 quarter. (c) Full-year 2019 (1 mark) Take an effective tax rate from chart or 2018 comparative x Income from Continuing Operations before Income Tax (10,166m) (d) Explain any assumptions or reasoning you used in your choice (or use) of effective tax rate, above. (1 mark) E.g. I choose 25% because it seems to be stable around the average of 25% up to Sep- 12 quarter. (2) With respect to the issue in for which you have made some adjustments in (1), apply the FREQ framework: (a) FREQ label: principles of financial reporting/ earnings quality addressed. (1 mark) Earnings management (b) FREQ elaboration. Note that both answers to (a) and (b) must be correct and consistent to earn these marks. (1 mark) Increasing Income from Continuing Operations by reducing income tax expense, whether GAAP or non-GAAP (c) INFERENCE Explain how you arrived at your FREQ conclusion, above. (2 marks) Fall in effective tax rate coincides with fall in revenue from Q1 2012, with a lag. which should have led to fall in earnings from 2012/3 but we see declines in effective tax rate consistent with IBM trying to earnings manage by reducing income tax rate. 2 Question 2 PART A (1) Consider the articles about IBM’s acquisition of Red Hat (previous page), and other financial information on IBM in this paper. (a) INFER: What in your opinion may have motivated IBM to have made this acquisition of Red Hat? (1 mark) Unable to organically grow that can be seen from revenue declines from 2012, need to grow by acquisition. (b) INFER: The Reuters article mentions investor concerns that IBM may have overpaid for this acquisition. What in your opinion may have motivated IBM to overpay? (1 mark) Pressure for management to seal the deal (2) FREQ: assuming IBM overpaid for Red Hat, what issues may arise in future? (a) FREQ label: principles of financial reporting/ earnings quality addressed (1 mark) Asset quality: (b) FREQ elaboration. Note that both answers to (a) and (b) must be correct and consistent to earn these marks. (1 mark) • overpay, future goodwill writedown PART B (1) Issue 1: ADJUST: how would you treat/adjust for such item(s) to IBM’s Revenue. (3 mark) Describe the item you are analysing: Divested Businesses If they did not divest the businesses IBM’s revenue would be 2.1 or 1.2 percentage points higher for 4Q and full-year, respectively (1) Issue 2: ADJUST: how would you treat/adjust for such item(s) to IBM’s Revenue. (3 mark) Describe the item you are analysing: Red Hat acquisition If not for Red Hat 4Q2019 revenue would be $573m lower, i.e. 21,777-573=21204, or 21204/21760 – 1 = 2.5% lower YoY (3) The above 2 items share the same FREQ. Label and explain then below. (a) FREQ label: principles of financial reporting/ earnings quality addressed (1 mark) Comparability (b) FREQ elaboration. Note that both answers to (a) and (b) must be correct and consistent to earn these marks. (1 mark) Acquisitions & disposals that are consolidated or unconsolidated make the current period less comparable than the prior period. 3 Question 3 PART A Consider the information on IBM 4Q2019 regarding the currency impact on revenue on p.7 of this paper. (1) FREQ: why would IBM present its results in this way? (a) FREQ label: principles of financial reporting/ earnings quality addressed (1 mark) Proforma: (b) FREQ elaboration. (1 mark) To show that it would have done better if not for currency movements (Alternate: Faithful representation) (2) INFER: explain the direction in movements of currencies in the countries that IBM operates relative to its home country? (1 mark) The USD rose against other currencies (3) ADJUST: how would you treat/adjust for such item(s) to IBM’s Total Revenue. (1 mark) If not for currency movements IBM’s revenue would be 0.6 or 2.1 percentage points higher for 4Q and full-year, respectively, so adjusted revenue increase to (constant currency): • 4Q 2019 = 21,777 * (1+0.006) = $21,907.66M • FY 2019 = 77,147 * (1+0.021) = $78767.087M Use the GAAP revenue growth of 20.7% and ignore currency and other non-GAAP adjustment impact. PART B (1) For the principal value of the loan raised in offshore markets: (a) FREQ label: principles of financial reporting/ earnings quality addressed (1 mark) FREQ: liability expansion: higher USD means higher liability in AUD. (b) FREQ elaboration. Note that both answers to (a) and (b) must be correct and consistent to earn these marks. (1 mark) Higher AUD if recognised, or even if not, means lower accounting of economic equity (c) Explain the steps of how it will impact shareholders equity (1 mark) As their assets are in AUD and cannot increase as liabilities increase in AUD even as it is nominally the same in foreign currency, the liability increase will eat up their equity. (2) For the interest expense of the loan raised in offshore markets: (a) FREQ label: principles of financial reporting/ earnings quality addressed (1 mark) FREQ funding cost with higher rates (b) FREQ elaboration. Note that both answers to (a) and (b) must be correct and consistent to earn these marks. (1 mark) Higher bank demand for offshore loans due to funding gap will result in higher interest rates required by investors. Higher liability leads to higher credit risks and higher interest rate to compensate. Lower AUDUSD means interest expense in USD will mean higher AUD interest expense (c) Explain the steps of how it will impact shareholders equity (1 mark) 4 Increases interest expense and lowers profit, leading to lower equity when profit is transferred to retained earnings in income summary. 5 Question 4 PART A (1)(a) Give your critical opinion on the appropriateness of the accounting rule on the initial recognition of goodwill, where the underlying fair value of assets acquired is negative. Note that simply restating the existing accounting rule will earn no marks. (4 marks) Some critical write-up is required considering the different methods for Internal generated versus external purchase Why recognize and not write-off, esp. when acquired business has net liability Neutrality or conservatism Some other issues Recognising goodwill instead of writing it off will incentivise management to overpay Exemplar student answer The accounting rule that the negative underlying fair value of assets acquired be recognised as goodwill of a company is incredibly narrow, foolhardy and essentially an accounting fiction. This is because goodwill is still represented as an asset when really it should be a write down (expense) thereby representing the true value of the underlying assets of the acquired company as at the end of the day it is not goodwill that produces the good or service being sold nor does it satisfy the obligations of the liabilities that the firm has taken on through the acquisition. As such this rule simply allows companies to hide terrible or questionable acquisitions as an asset on their balance sheet and when coupled with the testing of goodwill allows this to be perpetuated on an ongoing basis as it can be easily gamed. With goodwill being shown as an asset even though it is essentially an overpayment it leads to issues such as asset quality which can affect the solvency of the company when stressed. This may need to be adjusted for the balance sheet by exclusion or amortising in the income statement. The initial recognition of this acquisition is not appropriate. Since the fair value of asset acquired is negative, it means the acquisition is a total loss for the operation. Conservatively, it should record as a loss. Given GE recognised it as an asset and record goodwill, the later negative operating outcome should impair this goodwill. I think it is not appropriate to capitalise goodwill while the underlying fair value of assets acquired is negative. The amount of goodwill is measured by the company which performed acquisition. The amount of goodwill is subjective, which is less likely reliable. The goodwill cannot be sold when the business fail. It worth nothing particularly when the fair value of assets acquired is negative. The initial recognition of goodwill is treated as an asset, when purchase price exceeds fair value of identifiable net assets. When such underlying fair value of assets is negative, the goodwill recognized as asset may be even greater. Based on accounting standards, goodwill is determined as a premium that a company pays, and represents potential future earnings and other benefits that may not be separately identifiable and reliably measured, such as network effects. However, in my opinion, especially when fv of assets acquired is negative, there should not be any initial recognition of goodwill as this is more prudent. This will temper investor expectations, and reduces earnings management that presents assets in a better light. 6 When the underlying fair value is negative, it probably means that the assets acquired are high risk assets and not sure if the assets can generate enough benefit in the future. For conservatism, i think company should treat the goodwill as cost of acquisition rather than an asset . I do not believe that the accounting rule for goodwill’s initial recognition in such circumstances is appropriate. This is primarily because it allows for any purchase which has a positive payment made for it to appear as an asset on the balance sheet. This may well not be the case, and is an artificial inflation of assets. Further, it is meant to represent future profits that should be realised. In the case of an acquisition with negative fair value, it is highly possible that these profits will never occur, and so the goodwill that has such a large value, is effectively meaningless. [It is possible to take the opposite side of the argument, but a good student answer was not provided.] (2) ADJUST: how would you treat/adjust for such items. Must be consistent with opinion, above. (1 mark) e.g. if purchased business is negative value (net liability) write-off difference instead of recognising goodwill. PART B (2)(a) Give your critical opinion on the appropriateness of the accounting rule on existing goodwill that requires it to be periodically tested for impairment rather than to be amortised. Note that simply restating the existing accounting rule will earn no marks. (4 marks) Some critical write-up is required considering the different methods for Why is goodwill considered infinite life asset, when no business has lasted forever Why no amortisation but annual impairment test: amortisation Neutrality or conservatism Some other issues Impairment test is discretionary Exemplar student answer The existing accounting rule in regards to goodwill can be exploited rather easily as the company can game the rule requiring impairment which is if there is evidence that future cash flows from the underlying asset have deteriorated sufficiently to warrant a write-down. This rule is fraught with issues as it does not specify what is deemed sufficient, for how long it must not be sufficient (yearly, quarterly, 10 years? For example.) Even if it was to not have thee aforementioned issues goodwill now has an unlimited life time rather than being amortised over 20 years as previous as such the worth of a brand can continue being reported as it was 10, 20 or even 50 years ago if the company successfully games the test. As such it can become non representative of the actual value of the underlying intangible goodwill which should reflect the effective cost of conducting the transaction that ultimately should be amortised as the revenues and profits of the aforementioned transaction flow in over the following periods. 7 I think it is inappropriate to periodically tested for impairment rather than to be amortised. Periodically tests of goodwill give companies a lot of opportunities to delay goodwill Impairment. Company could delay goodwill impairment to show better performance and leverage ratio. When the company in trouble, the goodwill cannot be sold to help the company financially. So, when the company decide to recognise a large amount impairment of goodwill, which would significantly impact company’s stock price, it would be considered too late for investors to know that. The periodic testing of impairment of goodwill is done when there exists any evidence that future cash flows from the underlying asset have decreased significantly that there should be an asset writedown. This is the current rule on goodwill, and the old rule is amortization of 20 years. In my opinion, the old rule should still be in existence, and the current rule of impairment testing should be abolished. Impairment testing can be easily manipulated based on company discretion of using certain assumptions and valuation models. This may lead to a poor reflection of true value of the underlying asset. Through amortization, there is a definite recognition of expense and use of such asset. In addition, if PPE and certain intangibles are depreciated and amortized, it is prudent to also amortize goodwill. [It is possible to take the opposite side of the argument, but a good student answer was not provided.] (2) ADJUST: how would you treat/adjust for such items. Must be consistent with opinion, above. (1 mark) e.g. amortise goodwill against income 8 Question 5 (1)(a) What is the derivative risk ratio of Deutsche Bank, using their disclosure of their total derivative exposure in the table titled “Leverage ratio common disclosure”? (1 mark) 215/(some capital item e.g. shareholders equity = 62.678; CET1 or CET 1+2) (b) You should explain the choice of capital in your ratio, above. (1 mark) Any reasonable explanation. (2)(a) Explain why Deutsche Bank’s the net values of positive and negative market values of the derivative positions in the table titled “Notional amounts of OTC derivatives on basis of clearing channel and type of derivative” is not the same value as the total derivative exposure in 1(a). (2 marks) The net values are the accounting recognition of all the derivatives with an unrealized gain (positive values) recognized as assets, and unrealized (negative value) losses recognized as liabilities. They are the mark to market values as at balance sheet not the potential risk of losses in the event of a financial crisis. Whereas derivative exposure of 215m is what is the expected loss from derivatives in case of some crisis event. (b) Explain whether Deutsche Bank’s net values of positive and negative market values of the derivative positions in the table titled “Notional amounts of OTC derivatives on basis of clearing channel and type of derivative” is consistent with the FREQ notion of conservatism? (1 mark) Not conservatism: which would not recognize positive values as assets, and would recognize negative values directly to income statement as losses. (3)(a) What is the derivative risk ratio of Deutsche Bank, in the worst case scenario? (1 mark) 41940/(some capital item e.g. shareholders equity = 62.678; CET1+2=64522; T1 fully loaded=48.7) (b) Explain the reasoning behind your choice of derivative risk exposure in the worst case scenario (2 marks) Worst case scenario is the total notional exposure, without hedges (bilaterally netted) Because hedges may not work in a crisis because of counter-party risk, i.e. may be unable to pay out the hedge (4) Explain why in the table titled “Reconciliation of shareholders’ equity to regulatory capital”, items such as “Goodwill and other intangible assets …” is subtracted to arrive at definitions of regulatory capital such as Common Equity Tier 1 capital. (2 marks) Not saleable on standalone basis No value in a crisis 9 Question 6 PART A The information from the Balance Sheet and Note 24 to the accounts from Woolworth’s 2014 annual report provide information regarding the Company’s defined benefit plan. From a FREQ viewpoint, what does the defined benefit plan represent? (1) (a) FREQ label: principles of financial reporting/ earnings quality addressed (1 mark) Defined benefit plans are off-balance sheet items (b) FREQ elaboration. Note that both answers to (a) and (b) must be correct and consistent to earn these marks. (1 mark) Accounting rules only require the net asset/liability position to be put on the balance sheet, not the separate value of assets and of liabilities to be consolidated. (2) ADJUST: in analysing the FREQ impact of defined benefit plans, calculate the leverage of Woolworths for 2014 before and after grossing-up for the defined benefit plan. You may use the leverage ratio of your choice. (2 marks) (a) Before gross-up: 10,525.4/24205.2=43.48% (b) After gross-up: 10,525.4/(24,205.2+454.9=24,660.1) =42.68% (3) Consider the assumptions underlying Woolworth’s defined benefit plan: (a) If the 2014 assumption for “Discount rate” was 4.00%, what would be the impact on liability? (1 mark) Lower liability because a higher discount rate discounts future superannuation payments to a smaller present value. (b) If the 2014 assumption for “Discount rate” was 4.00%, what would be the impact on net interest expense on net defined benefit liability in 2014? (1 mark) There being a net liability, we have a net interest expense, a higher discount rate means higher interest expense. (c) If the 2014 assumption for “Expected rate of salary increase” was 2.50%, what would be the impact on the net income in 2014? (1 mark) A lower expected rate of salary increase means lower current service cost, and thus higher net income. (d) Explain why Woolworths did not make any assumptions for expected return on plan assets? (1 mark) As Woolworths applies IFRS, that assumption is irrelevant. PART B (1) U.S. Public Pension funds such as that in Minnesota currently use a discount rate of around 7.5%. Given that we are experiencing a global phenomenon of central banks reducing policy interest rates, label and explain the FREQ of pension funds having to adjust their discount rates. (1 mark) (a) FREQ label: principles of financial reporting/ earnings quality addressed (1 mark) Liability expansion (b) FREQ elaboration. Note that both answers to (a) and (b) must be correct and consistent to earn these marks. (1 mark) A reduction of interest rates will likely lower discount rate applied, resulting in higher DBP liabilities.
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