Income from Continuing Operations
Income from Continuing Operations
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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.
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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.
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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.
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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.
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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
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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