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A.4. Advanced Financial Topics Flashcards

Understand the impact of foreign currency, inflation, accounting changes, market value, and earnings quality on financial analysis. (60 cards)

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1
Q

What are the two main impacts of foreign exchange rate changes on a company’s financial statements?

A
  • Foreign currency gains and losses from transactions.
  • Foreign currency remeasurement gains and losses and foreign currency translation adjustments.
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2
Q

How are foreign currency transactions initially recorded in a company’s books?

A

In the company’s currency of record using the spot exchange rate on the transaction date.

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3
Q

How are outstanding receivables or payables that are denominated in a foreign currency reported subsequently on financial statement dates?

A

At each financial statement date, they are adjusted to their values in the company’s currency of record at the exchange rate on the financial statement date. Unrealized gains or losses are recorded as financial, that is, nonoperating unrealized gains or losses on the income statement.

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4
Q

Fill in the blanks:

When a multinational company has a subsidiary in another country whose financial statements are consolidated with its own, the currency the subsidiary uses to keep its books is called the subsidiary’s ________ __ ________.

A

currency of record

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5
Q

Fill in the blanks:

When a multinational company has a subsidiary in another country whose financial statements are consolidated with its own, the currency in which the subsidiary issues its financial statements is called its ____________ ____________

A

reporting currency

When the entity’s financial statements are being consolidated with those of its parent, the foreign entity’s reporting currency is the parent’s rleporting currency. The transactions executed by the foreign entity must be reported in the parent’s reporting currency so that users of the company’s consolidated financial statements can properly analyze the statements.

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6
Q

Fill in the blanks:

When a multinational company has a subsidiary in another country whose financial statements are consolidated with its own, the currency of the primary economic environment in which the foreign entity operates is called its ____________ ____________.

A

functional currency

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7
Q

When a multinational company has a subsidiary in another country whose financial statements are consolidated with its own, if the foreign entity’s functional currency is different from its currency of record, the entity’s financial statements must be converted to its functional currency before they can be converted to its reporting currency.

What is conversion of a foreign entity’s financial statements from its currency of record to its functional currency called?

A

Remeasurement

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8
Q

What is the objective of remeasurement of the financial statements of a foreign subsidiary prior to consolidation with the parent’s financial statements, when the foreign entity’s functional currency is different from its currency of record?

A

To produce the same result as if the entity’s books of record had been maintained in its functional currency all along, instead of in its currency of record.

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9
Q

What is the first step in preparing a foreign subsidiary’s financial statements for consolidation with a U.S. parent?

A

The restatement of financial statements prepared under accounting standards other than U.S. GAAP, such as IFRS, into financial statements prepared according to U.S. GAAP.

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10
Q

What is remeasurement in the context of foreign currency financial statements?

A

It is a step in the process of preparing a foreign subsidiary’s financial statements for consolidation with the parent’s financial statements.

Remeasurement is conversion from the foreign entity’s currency of record to its functional currency.

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11
Q

What is the definition of the functional currency of a foreign entity?

A

The currency of the primary economic environment in which the entity operates.

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12
Q

What are the most likely indicators of a foreign entity’s functional currency?

A
  • The currency of its cash flows
  • The currency in which its sales prices are denominated
  • The currency in which sales are made
  • The currency in which expenses are denominated
  • The currency in which financing is received
  • The currency in which any intra-party transactions are denominated
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13
Q

When is remeasurement not required for a foreign entity’s financial statements?

A

When the foreign entity’s functional currency is the same as its currency of record.

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14
Q

What method is used for remeasurement of a foreign subsidiary’s financial statements from its currency of record into its functional currency?

A

The monetary/nonmonetary

(temporal method)

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15
Q

How is the monetary/nonmonetary (temporal) method of remeasurement performed?

A
  • Monetary assets and liabilities are remeasured at the current exchange rate at the balance sheet date.
  • Nonmonetary assets and liabilities are remeasured at the historical exchange rates in effect when each transaction occurred.
  • Stockholders’ equity items, other than changes in retained earnings from net income or net loss, are remeasured at the historical exchange rates in effect when each transaction occurred.
  • Income statement amounts related to nonmonetary assets and liabilities, such as cost of goods sold (related to inventory), are remeasured using the same historical rate as is used to remeasure the non-monetary balance sheet items they are related to.
  • Other revenues and expenses that occur evenly throughout the period are remeasured using a weighted average exchange rate for the period.
  • Each year’s remeasured net income or net loss is transferred to retained earnings on the remeasured balance sheet.
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16
Q

Because different exchange rates are used for the various balance sheet and income statement items, the balance sheet will not balance after remeasurement.

How are remeasurement gains and losses recognized in the consolidated financial statements?

A

Any gain or loss that results from the remeasurement is recognized currently in earnings as a part of income from continuing operations.

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17
Q

What must be done to consolidate a foreign subsidiary’s financial statements with those of its U.S. parent if a foreign entity’s financial statements are prepared under non-U.S. GAAP standards, such as IFRS?

A

The foreign subsidiary’s financial statements must be restated to reflect U.S. GAAP as the first step in consolidation with the financial statements of the U.S. parent.

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18
Q

When a foreign entity’s financial statements are consolidated with those of its U.S. parent, what is the foreign entity’s reporting currency?

A

the U.S. dollar

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19
Q

What is the role of management judgment in determining a foreign entity’s functional currency?

A

To determine the functional currency in which financial results and relationships will be measured with the greatest relevance and reliability.

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20
Q

What is remeasurement in the context of foreign currency financial statements?

A

It is the process of converting a foreign entity’s financial statements from its currency of record to the entity’s functional currency as a step in preparing the statements for consolidation with the parent’s financial statements. Remeasurement is accomplished using the monetary/nonmonetary method.

Remeasurement is necessary when the foreign entity’s functional currency differs from its currency of record, and its objective is to produce the same result as if the foreign entity’s books had been kept in the functional currency all along, instead of in its currency of record.

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21
Q

When the monetary/nonmonetary method is used to remeasure a foreign entity’s financial statements from its currency of record into its functional currency, what are monetary assets and liabilities, and what exchange rate is used to remeasure them?

A

These are assets and liabilities whose amounts are fixed in terms of units of currency without reference to future prices. Examples of monetary assets and liabilities are cash, accounts receivable, accounts payable, and notes payable.

Monetary assets and liabilities are remeasured at the current exchange rate at the balance sheet date.

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22
Q

When the monetary/nonmonetary method is used to remeasure a foreign entity’s financial statements, what are nonmonetary assets and liabilities, and what exchange rate is used for their remeasurement?

A

Nonmonetary assets are assets that cannot be readily converted into cash and for which value cannot be precisely determined and may fluctuate over time.

Nonmonetary liabilities represent an obligation to provide a good or service rather than an obligation to make a cash payment.

Nonmonetary assets and liabilities are remeasured at the historical exchange rates in effect when each transaction occurred.

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23
Q

When the financial statements of a foreign subsidiary of a U.S. company are in accordance with U.S. GAAP and are expressed in the foreign entity’s functional currency, if its functional currency is different from its reporting currency (the U.S. dollar), how are the subsidiary’s financial statements converted from its functional currency into U.S. dollars for consolidation with the U.S. parent?

A

Translation

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24
Q

When a foreign entity’s financial statements are consolidated with those of its U.S. parent, what is the effect of remeasurement from the foreign entity’s reporting currency to its functional currency if its functional currency is the same as its reporting currency (the U.S. dollar)?

A

Remeasurement converts the foreign subsidiary’s financial statements from its currency of record to its functional currency. If its functional currency is the same as its reporting currency (the U.S. dollar), translation is unnecessary for consolidation with its U.S. parent’s financial statements because the subsidiary’s financial statements are already converted to its reporting currency.

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25
What is translation in the context of foreign currency financial statements?
It is the process of converting a foreign subsidiary's financial statements from the subsidiary's functional currency to its reporting currency for consolidation with the parent's financial statements, using the current rate method.
26
What method is used for translation of a foreign subsidiary's financial statements from its functional currency into its reporting currency?
Current rate method
27
How is translation to convert financial statements of a foreign subsidiary from its functional currency to its reporting currency accomplished using the current rate method?
* All balance sheet amounts except for stockholders’ equity are translated at the current exchange rate as of the balance sheet date. * Stockholders’ equity amounts, other than changes in retained earnings from net income or loss, are translated at the historical exchange rates in effect when each transaction occurred. * Translated retained earnings is the cumulative translated net income or net loss. * All revenues and expenses may be translated at the weighted average exchange rate for the period; or the historical rate in effect when each transaction occurred may also be used, if practicable.
28
Because different exchange rates are used for the various balance sheet and income statement items, the balance sheet will not balance after translation. What is the difference called, and how is it accounted for?
The difference is called a “**translation adjustment**.” It is not called a gain or a loss. Translation adjustments are recognized directly in stockholders’ equity as a component of accumulated other comprehensive income. Cumulative foreign currency translation adjustments for a particular foreign entity remain in AOCI while the foreign entity remains part of the consolidated group. They are reclassified to net income as realized gain or loss upon the sale or liquidation of that entity.
29
What is the impact of inflation on financial statements?
Inflation causes distortions in historical-cost statements, affects purchasing power, and can lead to overstated net income. ## Footnote Inflation acts as a "tax" on cash balances and affects the value of assets and liabilities differently.
30
What are the three methods of accounting for changes or corrections?
* Retrospective application * Restatement * Prospective adjustment ## Footnote Each method is used depending on whether the change is in accounting principle, reporting entity, or estimate, or if it is a correction of an error.
31
What is retrospective application, a method of accounting for changes and corrections, used for and how is it accomplished?
Retrospective application is used for changes in accounting principle and changes in reporting entity, applying a different accounting principle to prior periods as if it had always been used. The cumulative effect is reflected in the opening balances of assets and liabilities, with an offsetting adjustment to opening retained earnings, for the first period presented. The financial statements for all periods presented are adjusted for the effects of the correction.
32
What is restatement, a method of accounting for changes and corrections, used for and how is it accomplished?
Restatement is used to correct an error in previously issued financial statements. The cumulative effect of the error correction is reflected in the opening balances of assets and liabilities, with an offsetting adjustment to opening retained earnings, for the first period presented. The financial statements for all periods presented are adjusted for the effects of the correction. ## Footnote The restated financial statements must be identified as such, using the term "restated" only for error corrections.
33
What is prospective adjustment, a method of accounting for changes and corrections, used for and how is it accomplished?
Prospective adjustment is used for a change in accounting estimate and a change in accounting estimate effected by a change in accounting principle. The change is accounted for in the current period and future periods. No changes are made to prior period financial statements nor to any opening balances.
34
What method of accounting for changes and corrections is used for a change in an accounting estimate?
Prospective adjustment ## Footnote No changes are made to prior period financial statements nor to any opening balances. The change is accounted for in the current period and future periods if applicable.
35
What method of accounting for changes and corrections is used for a change in accounting principle?
Retrospective application ## Footnote Prior period financial statements are adjusted to reflect the effects of the new accounting principle unless it is impracticable to do so.
36
What method of accounting for accounting changes and corrections is used for a correction of an error in financial statements?
Restatement ## Footnote The restated financial statements must be identified as restated, and the term “restated” is to be used only for error corrections.
37
What method of accounting is used for a change in accounting estimate effected by a change in accounting principle, and what is an example of such a change?
Prospective adjustment is used. The change is accounted for in the current period and in future periods. Example: A change in depreciation method is a change in accounting principle. It is accounted for prospectively as if it were a change in accounting estimate, but It remains a change in accounting principle.
38
How is a change in reporting entity accounted for?
Retrospective application ## Footnote A change in reporting entity occurs when a change results in financial statements that are for a different reporting entity than was previously reported on. A change in reporting entity can occur if consolidated financial statements are prepared in place of separate statements for each individual entity or if a change takes place in the subsidiaries or companies included in the consolidation.
39
# True or False: A change from a non-GAAP method of accounting to a GAAP method is a change in accounting principle.
False ## Footnote A change from a non-GAAP accounting method to a GAAP method is a correction of an error.
40
How can the impact of accounting changes and corrections on financial ratios be determined?
When a change is made to financial statements, account balances change, affecting any ratios that are calculated using those account balances. To determine the impact on financial ratios, calculate the ratios before the change in accounting treatment, then calculate the revised account balances, then recalculate the ratios.
41
What is the difference between book value and market value?
* Book value: The book value of a piece of equipment is the original cost of the equipment less accumulated depreciation. The book value of a company is its total assets less its total liabilities. * Market value: For a publicly held company, market value is its market capitalization, calculated as the market price per share multiplied by the number of shares outstanding. ## Footnote Book value is based on historical costs, while market value reflects current market conditions.
42
What is economic profit?
The amount by which total revenue exceeds total economic costs, and "total economic costs" include both explicit and implicit costs. ## Footnote Economic profit considers opportunity costs, unlike accounting profit.
43
What are the main **implicit costs** included in the calculation of economic profit?
* Interest lost on money invested in the business instead of elsewhere, * Accounting profit that could be earned from alternative use of resources * Normal profit from entrepreneurial skills * Economic depreciation, the decrease in the market value of the fixed assets during the period, calculated as the market value of the assets at the beginning of the period minus the market value of the assets at the end of the period.
44
How is economic depreciation different from accounting depreciation?
Economic depreciation is the decrease in the market value of fixed assets during a period, while accounting depreciation is a mathematical construct used to expense the historical cost of fixed assets over their useful lives.
45
What is the definition of normal profit in the context of economic profit?
It is the value of an individual’s entrepreneurial skills in terms of the wages that the individual gives up by not working at another job. ## Footnote Normal profit is a cost, not a profit.
46
# Define: Earnings quality
It refers to the degree to which a company’s reported earnings faithfully represent the company’s true economic performance (good or bad) and provide useful information for predicting the company’s future earnings and cash flows. ## Footnote It is important for an analyst to be able to recognize whether earnings are of high quality or low quality before using them to predict a company’s future performance.
47
What factors determine earnings quality?
* The company’s business environment * Management's selection and application of accounting principles * The character of the company's management * Other earnings quality considerations, such as whether R&D efforts are sustained or whether they vary. If they vary, they usually lack the quality of a long-term program that is sustained.
48
# True or False: Earnings from increased sales volume are of higher quality than those from inflation.
True ## Footnote Inflation reduces earnings quality because it creates "inventory profits." When the old, lower-cost inventory is sold and is replaced by higher-cost inventory, inventory costs will catch up to current prices, margins will be compressed, and the inventory profits will evaporate.
49
What is the impact on earnings quality of using aggressive accounting policies?
Aggressive accounting policies lower earnings quality because they result in faster reporting of income, leading to higher short-term earnings but potentially lower earnings in later periods.
50
# Define: Earnings persistence
It refers to the constancy of a company’s earnings over time, something that is desired by investors. ## Footnote However, in gauging a company's earnings persistence, analysts should be aware that earnings management may be used to make income seem more stable and predictable than it really is. Earnings management leads to low earnings quality because the earnings do not faithfully represent the company’s true economic performance and do not provide useful information for predicting the company’s future earnings and cash flows. Earnings management involves using the discretion available to management to selectively apply acceptable accounting principles to achieve a specific earnings amount.
51
What is earnings management?
It involves using the discretion available to management to selectively apply acceptable accounting principles to achieve a specific earnings amount.
52
What is the goal of earnings management?
To moderate the variability of earnings across periods by shifting earnings from one year to another. Earnings management can be used in a fraudulent manner to misrepresent financial results materially and intentionally and deceive stakeholders about the true performance, profitability, and growth trends of a company.
53
What are the determinants of **earnings persistence**?
* Earnings variability: fluctuations in earnings caused by the business cycle, leading to undesirable stock price changes. * Earnings trend: analysis of earnings patterns over time to assess consistency and sustainability and help stakeholders evaluate earnings quality and predict future results. * Management incentives: motivations such as compensation plans and other accounting-based incentives that may lead management to distort or manipulate reported earnings. * Earnings management: selective application of acceptable accounting principles to achieve a specific earnings target.
54
How can an analyst identify the persistent components in financial statements when it appears earnings management has been used in the reporting?
By recasting and adjusting the reported earnings. **Recasting earnings** involves rearranging the earnings components within an income period to create meaningful classifications for analysis. **Adjusting earnings** involves moving items to different periods.
55
What is one method of earnings management involving current and future earnings?
Understating reported earnings to create a "reserve" for future use if earnings dip.
56
How can changes in accounting methods be used in earnings management?
By changing assumptions, such as increasing the assumed rate of return on a defined benefit pension plan to increase reported earnings or the estimated lives of fixed assets may be extended to decrease the annual depreciation recognized.
57
What is a "big bath" in the context of earnings management?
Recognizing future period costs in the current period when the current period is already reflecting poor performance to make future years look better.
58
How can the timing of transactions be used in earnings management?
Recognition of revenues and expenses may be timed by actual timing of transactions.
59
What is the potential consequence of excessive income smoothing?
The SEC may investigate and impose fines.
60
What is the risk to investors of a company using earnings management in a fraudulent manner?
It can deceive investors about the true performance, profitability, and growth trends of a company. If financial reporting fraud has been taking place, the historical financial statements may not be usable at all for predicting a company’s future earnings and cash flows.
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