Page 36 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 32.k: Describe accounting issues READING 32: RESIDUAL INCOME VALUATION
in applying residual income models.
MODULE 32.5: STRENGTHS/WEAKNESSES

Needed adjustments to Net income and Clean Surplus Violations..

The clean surplus relationship (i.e., ending book value = beginning book value + net income − dividends) may not hold when
items, per IFRS or US GAAP, are charged directly to shareholders’ equity (not via income statement). Examples include:
• Foreign currency translation gains and losses (Cumulative Translation Adjustment, CTA) under the current rate method.
• Gains/losses on certain hedging instruments.
• Changes in revaluation surplus (IFRS only) for long-lived assets.
• Changes in the value of certain liabilities due to changes in the liability’s credit risk (IFRS only).
• Changes in the market value of debt and equity securities classified as available-for-sale.

Effect - net income is not correct, but book value is still correct.

Variations from Fair Value
The accrual method warrants many balance sheet items to be reported at book values that are significantly different than their
market values.

Common adjustments to the balance sheet necessary to reflect fair value include:
• Operating leases should be capitalized by increasing A and L by the PV of the expected future operating lease payments.
• Special purpose entities (SPEs) whose A and L are not reflected in the AFS of the parent company should be consolidated.
• Reserves and allowances should be adjusted; e.g. the allowance for bad debts should reflect the expected loss experience.
• Inventory for companies that use LIFO should be adjusted to FIFO by adding the LIFO reserve to inventory and equity,
assuming no deferred tax impact.
• The pension asset or liability should be adjusted to reflect the funded status of the plan, which is equal to the difference
between the fair value of the plan assets and the projected benefit obligation (PBO).
• Deferred tax liabilities should be eliminated and reported as equity if the liability is not expected to reverse (e.g., if the
deferred tax liability results from different depreciation methods for tax and financial statement reporting purposes, and if the
company is growing).