CFA Level-I

Financial Reporting Analysis

FinQuiz.com

Reading 31: Financial Reporting Standards

FRAMEWORK
	U.S. GAAP	IFRS	Similarities
Purpose of Framework	The FASB framework resides lower in hierarchy. Management is not required to prioritize it if no standard is available.	Management is explicitly required to prioritize the IASB framework if there is no standard or interpretation available.	Both the frameworks are similar in their purpose to assist in developing and assisting standards.
Objectives of financial statement	It provides different objectives for business entities versus non business entities.	It gives one objective for different business entities.	Both frameworks have a broad focus to provide relevant information to a wide range of users.
Underlying assumptions	Although it recognizes, but not given much prominence is given to accrual and going concern basis. In fact going concern assumption is not well developed in particular	Give importance to accrual and going concern basis
Qualitative Characteristics	Same characteristics but with a hierarchy ·    Relevance and Reliability are primary qualities. ·    Comparability is the secondary quality. ·    Understandability, treated as user-specific	It has the same characteristics (understandability, comparability, relevance and reliability) but there is no such hierarchy.	The characteristics are same.
Approach	Rules based approach in the past but moving towards adopting object oriented approach	Principles based approach
Financial statement elements (definition, recognition, and measurement)
Performance elements	Elements are revenues, expenses, gains, losses, and comprehensive income.	Revenues and Expenses
Financial Position elements	Asset: a future economic benefit. Term ‘Probable’ is used to define assets and liabilities elements.	Asset: a future economic resource with which future economic benefits are expected ‘Probable’ is a part of the framework recognition criteria.
Recognition of elements	Does not discuss “Probable” for recognition criteria. Has separate criteria based upon “Relevance”	IASB framework requires that it is probable that any future economic benefit to flow to/from the entity.
Measurement of elements	FASB generally prohibits revaluations except for certain categories which must be carried at fair value (discussed in later topics).	Revaluation is usually permitted (discussed in later topics)	Measurement attributes like historical cost, current cost, settlement value, current market value, and present value are broadly consistent.

Reading 32: Components and format of the income statement

	U.S. GAAP	IFRS	Similarities
Revenue Recognition	It specifies that revenue should be recognized when it is “realized or realizable and earned.” 1. There is evidence of an arrangement between buyer and seller. 2. The product has been delivered, or the service has been rendered. 3. The price is determined, or determinable. 4. The seller is reasonably sure of collecting money.	The basic revenue recognition deal with the definition of “earned.” The conditions are: 1. The entity has transferred to the buyer the significant risks and rewards of ownership of the goods; 2. The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; 3. The amount of revenue can be measured reliably; 4. It is probable that the economic benefits associated with the transaction will flow to the entity; and 5. The costs incurred or to be incurred in respect of the transaction can be measured reliably.
Revenue Recognition (Service)	Does not deal separately	The outcome of service can be estimated reliably, revenue associated with the transaction will be recognized with reference to the stage of completion of the transaction at the balance sheet date. The conditions to measure reliably are: 1. The amount of revenue can be measured reliably; 2. It is probable that the economic benefits associated with the transaction will flow to the entity; 3. The stage of completion of the transaction at the balance sheet date can be measured reliably; and 4. The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

Long term Contracts	Under U.S. GAAP, a different method is used when the outcome cannot be measured reliably, termed the “completed contract method.” Under the completed contract method, the company does not report any revenue until the contract is finished. Under U.S. GAAP, the completed contract method is also appropriate when the contract is not a long-term contract.	If the outcome of the contract cannot be measured reliably, then revenue is only reported to the extent of contract costs incurred (if it is probable the costs will be recovered). Costs are expensed in the period incurred. Under this method, no profit would be reported until completion of the contract.	IFRS provide that when the outcome of a construction contract can be measured reliably, revenue and expenses should be recognized in reference to the stage of completion. U.S. GAAP has a similar requirement. Under both IFRS and U.S. GAAP, if a loss is expected on the contract, the loss is reported immediately, not upon completion of the contract, regardless of the method used.
Barter	U.S. GAAP states that revenue can be recognized at fair value only if a company has historically received cash payments for such services and can thus use this historical experience as a basis for determining fair value.	Under IFRS, revenue from barter transactions must be measured based on the fair value of revenue from similar non barter transactions with unrelated parties (parties other than the barter partner)
Gross Vs. Net Reporting	To report gross revenues, the following criteria are relevant: 1. The company is the primary obligor under the contract, 2. bears inventory risk and credit risk, 3. can choose its supplier, and 4. has reasonable latitude to establish price. If these criteria are not met, the company should report revenues net
Depreciation Amortization			In most cases IFRS and U.S. GAAP, amortizable intangible assets are amortized using the straight-line method with no residual value.  Goodwill and intangible assets with indefinite life are not amortized. Instead, they are tested at least annually for impairment.
Discontinued Operations			The income statement reports separately the effect of this disposal as a “discontinued” operation under both IFRS and U.S. GAAP.
Extraordinary Items	Under U.S. GAAP, an extraordinary item is one that is both unusual in nature and infrequent in occurrence.	IFRS prohibits classification of any income or expense items as being “extraordinary.”
Earnings Per share	Under U.S. GAAP, equity for which EPS is presented is referred to as common stock or common shares.	Under IFRS, the type of equity for which EPS is presented is ordinary shares.	Both IFRS &U.S. GAAP require the presentation of EPS on the face of the income statement for net profit or loss from continuing operations.

Treasury Stock Method	Under U.S. GAAP, when a company has stock options, warrants, or their equivalents outstanding, the diluted EPS is calculated using the treasury stock method	Under IFRS, requires a similar computation but does not refer to it as the “treasury stock method.”
Comprehensive Income	According to U.S. GAAP, four types of items are treated as other comprehensive income. ·    Foreign currency translation adjustments. ·    Unrealized gains or losses on derivatives contracts accounted for as hedges. ·    Unrealized holding gains and losses on a certain category of available-for-sale securities. ·    Changes in the funded status of a company’s defined benefit post-retirement plans.

Reading 33: UNDERSTANDING THE BALANCE SHEET

	U.S. GAAP	IFRS	Similarities
Balance sheet illustrations	Under U.S. GAAP current assets and current liabilities are shown before long term assets and liabilities respectively. It requires that minority interests be presented on the consolidated balance sheet as a separate component of stock- holders’ equity and labeled separately.  Entity with multiple minority interests may present in aggregate.	Under IFRS the minority section is shown, as required, in the equity section. Noncurrent assets, as common practice are shown before current assets.
Measurement basis			The notes to financial statements and management’s discussion and analysis are integral parts of the U.S. GAAP and IFRS financial reporting processes.
Inventories	LIFO is allowed under U.S. GAAP along with FIFO, specific identification and weighted average	LIFO is not allowed under IFRS whereas FIFO, specific identification and weighted average are allowed

Specifically identifiable intangible assets	U.S. GAAP prohibits the capitalization as an asset of almost all research and development costs. All such costs usually must be expensed. Generally, under U.S. GAAP, acquired intangible assets are reported as separately identifiable intangibles (as opposed to goodwill) if they arise from contractual rights (such as a licensing agreement), other legal rights (such as patents), or have the ability to be separated and sold (such as a customer list).	Under IFRS, specifically identifiable intangible assets are recognized on the balance sheet if it is probable that future economic benefits will flow to the company and the cost of the asset can be measured reliably (externally purchased). IFRS prohibits the capitalization of costs as intangible assets during the research phase. Instead, these costs must be expensed on the income statement. Costs incurred in the development stage can be capitalized as intangible assets if certain criteria are met.	Internally created identifiable intangibles are less likely to be reported on the balance sheet under IFRS or U.S. GAAP rather expensed out
Goodwill			Under both IFRS &U.S. GAAP Goodwill should be capitalized and tested for impairment annually.

Reading 34: understanding the cash flow statement

	U.S. GAAP	IFRS	Similarities
Interests received	Operating cash flow	Operating or Investing cash flow
Interest paid	Operating cash flow	Operating or Financing cash flow
Dividends received	Operating cash flow	Operating or Investing cash flow
Dividends paid	Financing cash flow	Operating or Financing cash flow
Bank overdrafts	Not considered as cash or cash equivalents; classified as financing	Considered part of cash equivalent
Taxes paid	Operating	Generally operating but a portion can be investing or financing if identified separately with these categories
Format of statement	If direct is used reconciliation of NI with Operating cash flow must be provided	No such requirement to provide any reconciliation	Direct or Indirect; Direct is encouraged
Disclosures	If not presented on the cash flow statement, both interest and taxes paid must be disclosed in footnotes	Tax cash flows must be separately disclosed in the cash flow statement
Previous Years Statements	Three years of cash flow statements are provided	Two years of cash flow statements are provided

Reading 35: Financial analysis techniques

	U.S. GAAP	IFRS	Similarities
Segment Reporting	Requirements are similar to IFRS but less detailed. Disclosure of Segment Liabilities is a noticeable omission	IFRS requires the detailed reporting of segments

Reading 36: inventories

	U.S. GAAP	IFRS	Similarities
Cost of Inventories			Under both IFRS and U.S. GAAP the cots to be included in inventories and those needed to be expensed immediately are same.
Inventory Valuation Methods	LIFO is permitted	LIFO is not permitted	Under both IFRS and U.S. GAAP specific identification, weighted average and FIFO are allowed.
Measurement of Inventory Value	Inventories are measured at lower of costs or market where market is the current replacement cost which cannot be greater than NRV and lower than NRV minus Profit margin.	Inventories should be measured at lower of cost and NRV (net releasable value).
Reversal of Write-down	U.S. GAAP prohibits any reversal of write-down.	The amount of any reversal of any write-down of inventory arising from an increase in net realizable value is recognized as a reduction in cost of sales (COGS)
Mark to Market (presenting on fair value)			U.S. GAAP are similar to IFRS in the treatment of inventories of agricultural and forest products and mineral ores. Mark-to-market inventory accounting is allowed for refined bullion of precious metals.
Disclosures	U.S. GAAP require of disclosure of income from LIFO Liquidation and significant estimates related to inventories.	IFRS requires the amount of write down to be disclosed and the circumstances which led to the write down of inventories	Other disclosures are similar.

Changes in inventory valuation method

·    Under U.S. GAAP, a company making a change in inventory valuation method is required to explain why the newly adopted inventory valuation method is superior and preferable to the old method. ·    If a company changes from LIFO to any other method retrospective application is necessary. ·    If a company changes to LIFO method then prospective application is necessary

Under IFRS, a change in accounting policy, also cost formula, is acceptable only if the change results in the financial statements providing ·    reliable ·    more relevant information about the effects of transactions, other events, or conditions on the business financial position, financial performance, or cash flows.

Reading 37: long lived assets

	U.S. GAAP	IFRS	Similarities
Acquisition of Long lived Assets	U.S. GAAP does not net the interests.	Under IFRS, income earned on temporarily investing the borrowed monies decreases the amount of borrowing costs eligible for capitalization.
Intangible assets developed internally	U.S. GAAP requires both research and development costs to be expensed except for software development	Under IFRS the research cost is expensed whereas the development cost is capitalized as an intangible asset	The treatment of software development costs under U.S. GAAP is similar to the treatment of all costs of internally developed intangible assets under IFRS.
Intangible assets acquired in a Business Combination	Under U.S. GAAP, there are two criteria to judge whether an intangible asset acquired in a business combination should be recognized separately from goodwill: ·    The asset must be either an item arising from contractual legal rights ·    An item that can be separated from the acquired company	Under IFRS, the acquired individual assets include identifiable intangible assets that meet the definitional and recognition criteria. If it doesn’t then it will be recorded as goodwill
Depreciation/Amortization. of Long lived assets	U.S. GAAP requires the cost model of reporting for long lived assets	The cost model is permitted under IFRS
Revaluation method	U.S. GAAP do not permit the use of revaluation method	IFRS permits the revaluation method
Reviewing estimates	U.S. GAAP does not require companies to review their estimates affecting depreciation expense annually	IFRS requires companies to review these estimates annually
Component Method	Under U.S. GAAP the component method is allowed but is seldom used	IFRS requires companies to use component method of depreciation

Impairment of Assets	Reversal is not permitted under U.S. GAAP	Reversal is permitted under IFRS	Both IFRS and U.S. GAAP require companies to write down the carrying amount of impaired assets.
Impairment Test	Under U.S. GAAP an asset’s carrying amount is considered not recoverable when it exceeds the undiscounted expected future cash flows. The impairment loss is then measured as the difference between the asset’s fair value and carrying amount.	IFRS defines the recoverable amount as the higher of its fair value less costs to sell and its ‘value in use’ where ‘value in use’ is a discounted measure of expected future cash flows
Reversal of Impairment	Under U.S. GAAP, once an impairment loss has been recognized for assets held for use, it cannot be reversed. For assets held for sale, if the fair value increases after an impairment loss, the loss can be reversed.	IFRS permit impairment losses to be reversed if the recoverable amount of an asset increases regardless of whether the asset is classified as held for use or held for sale. IFRS do not permit the revaluation to the recoverable amount if the recoverable amount exceeds the previous carrying amount
Disclosures (Tangible Asset Class)	Under U.S. GAAP the requirements are less exhaustive. Disclosure includes: ·    Period’s depreciation expense ·    Balance of major classes of depreciable assets ·    Accumulated depreciation by major class or in total ·    General description of the depreciation method	Under IFRS for each class of PP&E a company should disclose ·    Measurement base ·    Depreciation method ·    Useful life used ·    Gross carrying amount ·    Accumulated depreciation at the beginning of each period ·    Restriction or title and pledge ·    Contractual agreement to acquire PP&E If revaluation model used then: ·    Date of revaluation ·    How fair value was obtained ·    Carrying amount under the cost model ·    Revaluation surplus (if any)

Disclosures (Intangible asset class)	Under U.S. GAAP companies are required to disclose: ·    Gross carrying amount ·    Accumulated amortization by asset class ·    Aggregate amortization expense for the period ·    Estimated amortized expense for the next 5 years	Under IFRS a company must disclose ·    Asset class is having finite or infinite life ·    If finite the company must disclose useful life ·    The amortization method used ·    The gross carrying value ·    Accumulated Amortization at beginning of each period ·    Reconciliation of carrying amount at the beginning and end of each period For indefinite life ·    Carrying amount & why it is considered with indefinite life Revaluation model disclosures are same if used
Disclosures (Impairment losses)	Under U.S. GAAP ·    Description of the impaired asset ·    Why impairment was done ·    Method of determining fair value ·    Amount of impairment loss ·    Where the loss is recognized on financial statements	Under IFRS ·    The amount of impairment loss ·    Reversal of impairment losses ·    Where they are recognized on financial statements ·    Main classes affected by impairment loss and reversal ·    Main events and circumstances leading to impairment loss and reversal.

Reading 38: income taxes

	U.S. GAAP	IFRS	Similarities
Deferred Tax Assets and Liabilities	Under U.S. GAAP deferred tax assets and liabilities are classified as current and noncurrent based on the classification of asset or liability	Under IFRS deferred tax assets and liabilities are always classified as noncurrent.
Economic Benefit does not match	Under U.S. GAAP a valuation allowance is established if deferred tax asset or liability resulted in past but the criteria of economic benefit does not match with current balance sheet	Under IFRS an existing deferred tax asset of liability related to the item will be reversed if it resulted in past but the criteria of economic benefit does not match with current balance sheet

Tax Base of a Liability	Under U.S. GAAP the tax legislation within the jurisdiction will determine the amount recognized on the income statement and whether the liability (revenue received in advance) will have a tax base greater than zero. This will depend on how tax legislation recognizes revenue received in advance.	IFRS offers specific guidelines with regard to revenue received in advance. It states the tax base is the carrying amount less any amount of the revenue that will not be taxed at a future date.	The analysis of the tax base results in similar outcome
Differences between Taxable & Accounting Profit	Under U.S. GAAP a deferred tax asset or liability is not recognized for unamortizable goodwill. There is no exemption for the initial recognition of asset or liability in transaction that ·    Is not a business combination ·    Affect nor accounting or taxable profit	Under IFRS, a deferred tax account is not recognized for goodwill arising in a business combination. Since goodwill is a residual, the recognition of a deferred tax liability would increase the carrying amount of goodwill. There is an exemption for initial recognition of asset or liability in transactions stated before	IFRS and U.S. GAAP both prescribe balance sheet liability method for recognition of deferred tax
Deductable Temporary Difference			Under IFRS and U.S. GAAP, any deferred tax assets that arise from investments in subsidiaries, branches, associates, and interests in joint ventures are recognized as a deferred tax asset. They both allow the creation of deferred tax asset in the case of tax losses and credits
Recognition of Tax Charged directory to Equity	Revaluations are not permissible under U.S. GAAP		Charged Directly to Equity In general, IFRS and U.S. GAAP require that the recognition of deferred tax liabilities and current income tax should be treated similarly to the asset or liability that gave rise to the deferred tax liability or income tax based on accounting treatment.

Reading 39: non-current liabilites

	U.S. GAAP	IFRS	Similarities
Bond Issuance	Under U.S. GAAP the issuance cost is recognized as an asset and amortized on straight line basis over the life of the bond	Under IFRS all issuance costs are included in the measurement of liability, bonds payable, and netted.	Under both U.S. GAAP and IFRS the issuance costs are included in cash outflow from financing activities and usually netted against bonds proceeds
Accounting Method for bond issuance	Under U.S. GAAP the effective interest method is preferred	Under IFRS the effective interest method is required
Reporting of Interest Payments	It is reported as operating cash outflow	Could be either report as operating or financing cash outflow

Reporting Option			IFRS and U.S. GAAP require fair value disclosures in the financial statements unless the carrying amount approximates fair value or the fair value cannot be reliably measured.
De-recognition of Debt	The debt issuance costs are accounted for separately from bonds payable. Any unamortized debt issuance costs must be written off at the time of redemption and included in the gain or loss on debt extinguishment.	The issuance cost are a part of the liability thus part of the carrying amount
Lease terminology	Capital lease is the terminology	Finance lease is the terminology
Classification as Finance/ Capital Lease	Though the principle is same but provisions are more specific ·    Ownership of the lease to be transferred at the end of the lease ·    Lease contains an option to purchase the asset at cheaply, bargain price option ·    Lease term 75 percent or more of the useful life of the asset ·    Present value of lease payments to be a least 90 percent of the fair value Lessee requires one of these criteria to consider lease as capital whereas Lessor requires at least one of the criteria plus meeting the reasonable assurance for getting the cash and performed substantially under the lease to record as capital lease.	·    Ownership is transferred to the lessee by the end of the lease term ·    Option to purchase the asset at price sufficiently less than the fair price ·    Lease term extended to major part of economic life of the asset, even the title is not transferred ·    At inception the present value of minimum lease payments be equal to the fair value of the asset ·    Asset can only be used by lessee unless major modifications are made Generally is all the risks and rewards associated with the asset are transferred, both the lessee and the lessor record finance lease
Interest portion of lease payment	U.S. GAAP consider the interest portion of lease payment as an outflow from operating activity	Either operating of financing cash outflow under IFRS for interest portion of the lease payment
Reporting by the Lessor	From lessor’s perspective there are two types of lease ·    Direct Financing: When present value of the lease  payments equals the carrying amount of the asset ·    Sales-type: When present value exceeds the carrying amount of the asset	Under IFRS there is no such classification but treatment is available when manufacturer is also the lessor.	Under IFRS and U.S. GAAP, if a lessor enters into an operating lease, the lessor records any lease revenue when earned. The lessor also continues to report the leased asset on the balance sheet and the asset’s associated depreciation expense on the income statement.
Actuarial gains/losses& Prior Service Costs			Both IFRS and U.S. GAAP allow the companies to smooth the effect of these two items over time

Net Pension Obligation

Under U.S. GAAP companies are required to measure the net pension obligation (asset) as pension obligation less plan assets.

Under IFRS companies can choose to measure net pension obligation. Companies alternatively can choose to exclude the unrecognized smoothed amounts resulted from actuarial gains/losses or prior service costs

Reading 43: international standard convergence

	U.S. GAAP	IFRS	Similarities
Long-Term Investments	U.S. GAAP requires the use of equity method for accounting interests in equity method U.S. GAAP uses a dual model based on voting control and economic control in accounting for investment in another area	IFRS permits the use of proportionate or equity method in joint ventures. IFRS uses voting control method to determine need for consolidation in accounting for investment in another area

The Charlie Theory

It sounds a kind of funny but if we take it in another way it seems quite productive, at least for me it worked really well! Although it has nothing to do directly with CFA Level II but the theory could really help in understanding the things well.
Way back in 2007 I had this remarkable experience of watching Charlie and the Chocolate Factory. Though I was impressed by the character Willie Wonka, but a lesson which I learnt from the young boy Charlie was unprecedented. In fact now a days my preparations for Level II are going on and Fixed Income will be finished by this week, the strategies which helped me out in maintaining myself in a better position to understand the complexities of Level II include the Charlie Theory. Though its the writer who deserves the credit but as it was adopted by Charlie that is why I'm referring it with his name.
It is a theory with two folds. One is tactical while the other is strategic. The strategic one is quite simple in narrating but very difficult in believing and ultimately sticking onto it! Since Charlie Bucket belonged to a very poor family who had nothing to eat and they were living in a very small house. The thing which altered his life was his belief in himself! He was not only a die hard lover of chocolate but also a firm believer of his dreams. This brings us to a very important lesson for doing great things in life! Always believe in yourself and never loose hope. This exactly is what Charlie did and ultimately became the successor of Willie Wonka, a crazy candy genius! Same could be implied for passing out the CFA Level II exam; what we require is a solid determination and a strong belief. Nothing is impossible in this world what we need to do is just converge our energies in understanding the topics and making ourselves excellent. Success is not only a relative term but it is also beyond our scope. What in our scope is the effort and belief in ourselves. Nothing in this world can stop us from achieving our aims and meeting our destination!
The other part of the theory is more of a tactical approach. As mentioned earlier, Charlie Bucket belonged to a very poor family and his father, the only earning hand in their family, lost his job due to automation. Things became so worst that they were left with nothing to eat! Charlie was in his growing age and required more food intake, when saw the situation ended up being efficient. He started walking to school in a speed which could conserve his energies. During the recess time he stopped playing withe children, avoided running, started to remain silent and hence everything which he could do to save his energies so that his food requirements must cohere with the available intake. Doing the same can dramatically help us in achieving our desired goals. We require loads of energies to understand the tricky concepts of Level II. There is so much to understand that our energy level must remain at sufficient level to cope up with the in-depth concepts. Applying the 2nd fold of Charlie Theory can help us in enhancing our focus. If we start neglecting the community of pessimistic people, keep ourselves away from disappointing news items, do not waste time in activities which require too much attention, I'm sure our efficiency can increase to the optimum level. Doing CFA is more like adopting a lifestyle. I believe if we espouse the Charlie Theory we can pull this off and pass this Level in this attempt.

Valuing Fixed Income Securities

To value fixed income securities the Treasury spot rate curves are used. They are theoretical spot rate which can be derived either by observing, bootstrapping or interpolation. Through observation the spot rates can only be derived from Treasury Strips but there are several advantages and disadvantages associated with that. Treasury Strips have the basic advantage of being available for every maturity. On the other hand the liquidity problem exists as a major disadvantage. They have tax disadvantages because of the accumulated interest on strips and there are certain regions where the Non U.S. investor is provided tax advantage. In this way unanimous tax adjustments cannot be done. It is important to understand that zero coupon bonds have no intermediate cash flows and for this reason their discounting factor is the spot rate. Yield is only involved in coupon paying bonds. For this reason the rate on Treasury Strips is considered to be the spot rate because each coupon payment is stripped and can trade as a zero coupon bond.
With On the run issues spot rates can also be derived using the bootstrapping method. In this method the 1 year zero coupon bond is taken and its yield is the spot rate for one year. Then a two year coupon paying bond is taken at par so that its yield to maturity is its coupon rate. The first years coupon payment is discounted at the rate of 1 year zero coupon bond, the spot rate, and the 2nd year's coupon plus principle is discounted with 2nd years spot rate. Since the equation is equal to the par value, the spot rate for 2nd year is calculated. Similarly it is applied for all the maturities to get the theoretical spot rates. This method is known as bootstrapping and the rates gathered through it if drawn graphically are known as Treasury Spot Rate Curve which in fact is used to value Fixed income securities. The issue with on the run securities is that they are not available for all the maturities and relatively liquid than off the run issues. Their price might disrupt the yield calculated from their prevailing prices. In this method the bootstrapping along with interpolation is used.
To counter this problem, a blend of on the run and off the run securities is used and the method of bootstrapping and interpolation is used to get the spot rate curve. Again which securities to use as for similar maturities sometimes multiple off the run issues are available. Some analysts are of the view to use all the issues of Treasury in order to get spot rates which is a complex task and requires diligence.
Can only the Treasury spot rates be used to value fixed income securities? The answer is no! Alternatively to Treasury spot rates curve, the Swap rate curve could also be used to value fixed income securities. It is a noticeable thing that Swap rate curve is an alternative to Treasury Yield curve, not Treasury spot rate curve. To determine spot rates through Swap rate curve the method of bootstrapping is used. Swap rates can be gathered by knowing the inter-bank lending rates. LIBOR is a renowned rate used by banks for lending, the swap rates curve against LIBOR is called the LIBOR rates curve. Bootstrapping the LIBOR rates curve results in LIBOR spot rates curve which is used to value fixed income securities. Due to their advantages, the swap rates are becoming famous and used instead of treasury yield curve. They are above the government regulations, available for more maturities, does not account the technicalities associated with bonds as the principal is 'assumed' not actual and supply of swaps depend upon the number of counterparts.
One must not forget that Swap rates are a proxy to Treasury Yield rates not to Treasury Spot rates where as the method of deriving spot rates is similar. Once spot rates are measured, the future rates can be derived against the spot rates. In this way the circle runs and we can value the fixed income securities. 

Role of Covenants in credit analysis

Indenture is referred to as the lending agreement which contains terms and conditions. These terms and conditions are referred to as covenants. They deal with limitations and restrictions on the borrower's activities and play an important part in minimizing risk of creditors. Covenants could be termed as either Affirmative or Negative.

Affirmative covenants are those which require debtors to do certain set of activities to improve the credit quality of the issuer. Common examples include:

• To pay all taxes and other claims when due
• To maintain all properties used in the borrower's business in working order and good condition
• To pay interest, principal, and premium, if any on timely basis
• To submit periodic certificates to the trustee stating whether the debtor is in compliance with the loan agreement.

Negative covenants are the limitations which restrict borrowers not to take certain actions. Common examples include:

• Limitations on the company's ability to incur debt
• Use of cash flow tests and working capital maintenance provisions
• Limitations on dividend payments and stock repurchase
• Use of interest or fixed charge coverage test to reduce the default risk of creditors. The two common tests are:
• Maintenance Test: This test requires the borrower's ratio of earnings available for interest or fixed charges to be at least a certain minimum figure on each required reporting date
• Debt Incurrence Test: Debt incurrence tests are generally considered less strict than maintenance provisions.

Indentures often classify subsidiaries as restricted or unrestricted. The former are considered for financial test purposes while the later are not. If a firm has unrestricted subsidiaries they are allowed to used outside sources of funds and they are excluded from the covenants of the parent.

Covenants are among the other Cs of Credit Analysis. They are given equal preference while checking the credit quality of an organization. If organizations fail to abide by the covenants then creditors feel reluctant in lending money to such organizations.

Cash Flow Analysis

Capacity to pay is an important element while analysing a company for credit ratings. Usually Traditional Ratio analysis is done to check the capability of a company meet its short term and long term debt obligations. Interestingly Traditional Ratios can give a deceived view. To counter that, eminent credit rating agencies do the cash flow analysis in order to truly judge the capacity of firms meeting their debt obligations. 

Knowing the sources for cash of a firm is an important consideration in this regard. A firm must be able to generate cash flows from its operations to have future prosperity and the ability to meet its obligations. Standards and Poors utilizes the criteria in which it adds depreciation and plus/minus other non cash items to Net Income in order to get Funds from Operations. They are adjusted for working capital to get operating cash flows which are further netted against capital expenditures (operating cash flow - capital expenditure) to get Free Operating Cash Flows. After subtracting cash dividends from Free Operating Cash flows they get Discretionary Cash flows. As its name implies these cash flows are on the discretion of the management to use. Netting these cash flows against acquisitions, adding asset disposals and adding (subtracting) other sources (uses) result in Pre-financing Cash Flows.

The flow can be illustrated as:

Net Income

Plus Depreciation

Plus/Minus: Other non cash items

Funds from Operations

Decrease (increase) in non cash current assets

Increase (decrease) in non debt current liabilities

Operating Cash Flow

Minus Capital expenditure

Free Operating Cash flow

Minus Cash dividends

Discretionary Cash flow

Minus acquisitions

Plus Asset Disposals

Plus (minus) other sources (uses)

Pre-financing Cash Flow

S&P uses the following cash flow ratios in order to analyse a company

1. Funds from Operations / Total debt (netted against off-balance sheet liabilities, leases etc.)

• Higher the ratio, the stronger the issuer's capacity to pay

2. (Free Operating Cash flow + interest) / Interest

• The higher the ratio, the stronger the issuer's capacity to pay.

3. Debt Service Coverage Ratio = (Free Operating Cash Flow + Interest) / (interest + Annual Principal Repayment Obligation)

• The higher the ratio, the stronger the issuer's capacity to pay

4. Debt Payback Period = Total Debt / Discretionary Cash Flow

• The lower the ratio, the stronger the issuer's capacity to pay

5. Funds from Operations / Capital spending requirements

• The higher the ratio, the stronger the issuer's capacity to pay.

It is noticeable that companies with lower credit ratings and Speculative-grade issuers must be analysed using

• Free Operating Cash Flows
• Debt service coverage ratios

High credit rating firms should be analysed using Funds from Operations measure.

Based on above methodologies one can see that cash flow analysis is not only interesting but capable of giving a direction which can be used to judge the capacity of a company to meet its debt obligations. Merely relying on traditional ratio analysis, which itself is an important tool but must not be considered the sole one, can give a view which could be misleading. 

Level II Diary - First Week

I could sense a peculiar feeling developing inside me while attending the Level II class. It was the same auditorium with similar arrangements but I was sitting on a different seat. Plenty of identical faces were present in the class with a few ones missing and several unrecognized. A new motivation was required to grasp the concepts of Level II as it seemed quite different from what we had studied in Level I. 

The major difference which I sensed was the in-depth understanding required of the topics. It started off with Fixed Income, Study Session 14, Reading 50 - Valuing bonds with embedded options. I could recall the first class in Level I which was different in a sense that the terminologies discussed were alien to me. The good thing was whatever was being discussed let it be the key terms, jargon and concepts, it had started to make sense. It was an interesting element as retaining things considering them facts without knowing their reason for existence was the most difficult task for me. 

The first question which troubled me was the relation of Volatility and Option Adjusted Spread for callable bonds. On the first day it was discussed in the class but I was able to figure out the answer after giving a complete reading of the chapter. As with the case of callable bonds, an increase in volatility increases the value of the call option and the option adjusted spread is calculated by subtracting option value from zero volatility spread. Understanding this relation made me figure out the logic behind a line written in text book that when the volatility increases the OAS decreases for callable bonds.

Using the interest rate tree and applying the concept of backwardation was another interesting topic which was covered during the first week. In fact it got even more attractive when it was used in valuing bonds with embedded options and floaters. Analysis of convertible bond was another important area which was covered in the first week and it got more valuable when we were told that Warren Buffet, an investment tycoon, purchased the convertible bonds issued by the Bank of America, which was in grave trouble those days. Securing the downside potential till the straight value, which in fact is a moving floor, of the bonds and having the chance of converting them into stocks when they outperform the fixed income securities, was an appealing aspect.

Towards the end of the week we covered the general principles of credit analysis. As I mentioned earlier, there is so much to learn and associate with the ‘real world’ in Level II that often it is hard to believe! The rating agencies which are considered experts and their opinions are disseminated over Bloomberg and Business week, we practically understood their methodology of rating other companies. Moody’s Investor Service, S&P Corporation, and Fitch ratings were the ones we discussed. The story didn’t stop on these companies in fact it started from them. Learning the ability to do credit analysis was the most interesting and appealing part of Reading 48. It equipped us with the skills required to do credit analysis by first figuring out questions through ratios and then answering them through cash flow, collateral and other investigations.

On the whole the first week was amazing in terms of learning and provided a deep ‘peep’ into the magical world of finance. Way back when I was in school I used to study a book named ‘How the Universe works?’ The first week reminded me off with my deep interest towards knowing things. Life may sometime in the future provide me with an opportunity to understand how the universe works but my joy of understanding how the finance universe works can’t be explained in words… For those who want to explore the different dimensions and levers of this magical world of finance, must take a bold step and become a part of this course. 

One month before the exam...

For Level 1 our course ended on Sunday, 8th of May 2011. Apparently it was hard for me to believe that in less than hundred days, we had completed 5 books covering 10 subjects. I could recall the first day when I had stepped into that auditorium. There was a sense of happiness and an increasing responsibility as only 1 month was left before the exam. I greeted my friends, left the class and gathered my energies to travel back to my house. It was economics which we had covered in just 3 days! I was simultaneously shocked and surprised. The book had three study sessions in it and around 15 chapters but we just skimmed it in three days!

While returning back to home, I was consistently planning the following week. Though when I had decided to travel in February 2011, it was among my principles not to bother much during travelling but the anxiety of the exam had made me break all the rules; my rules! After gathering much courage and potential I decided to revise 5 books in 6 days! Impossible, this is what I said to myself and rested my head back in the bus. The clock struck 1 and I left the bus at an interim terminal. My parents were waiting for me in the car, I ran towards them and after watching their faces all my anxiety and tiredness vanished. I came across to my house telling them all the details of the class and 'out bursting' what I had in my mind. It gave me energies. When I went into my house I realized that I was fresh. It was a hectic weekend, I had covered a complete book in three days, traveled 2 hours in the bus and still I was fresh. That was the moment I realized how necessary it is to remain happier in order to achieve one's goals. It seemed that I had conquered my devil. Nothing is impossible was the next thing which I told to my self and slept. 

Against all odds, I woke up early in the next morning and after a 'vibrant' breakfast I opened my books. I tried to remove all other things especially the fear out of my mind and started my reading. I had realized the organization of information which I had done during my previous readings helped me out dramatically in increasing my efficiency and capability of retaining. I started off with my best portion - Book 4 to gain confidence and completed the book in one day. It wasn't a continuous strive. I took brakes in the mean time, tried to make my self feel relaxed and rejuvenate. I ate well - it makes me happy, done some physical workout to gather energies for my brain, and watched funny short clips. Planning the leisure time and studying in the rest of time was the strategy which made me happy and ultimately completing one book in one day. The quest continued till Saturday 14th May, 2011. I left for Lahore in that evening and took a deep sleep. 

On Sunday 15th May, 2011 it was my first mock. I was fresh and excited. The curiosity was not the actual proxy of the exam yet I could sense a chunk of it! My aim was to check my stamina of sitting in the exam for 3 hours, waiting for 2 hours and then re-sitting for the next 3 hours. The first mock really helped out in evaluating where I had stood. Though I had passed that mock but when I was travelling back I was planning for the next week. 22nd May, 2011 was the destination and I had 6 days, and 5 books to cover...