Some key points:

• Institutions mark up prices to draw in buyers so that they can unload their positions to these buyers.
• Up bars with excessive volume are a sign of weakness.
• Down bars with high volume are a sign of strength.
• Low volume up bars signify no demand, and signals to the large operators that buying has dried up and mark-down can begin.
• Low volume down bars signals to the large operators that prices have been marked down enough and it is time to cover.
• Low volume down bars with a narrow spread (i.e. high – low) occurring near an old low means professional operators are bullish and are absorbing the supply.
• Low volume up bars with narrow spread occurring near an old high indicates that the market is weak and the demand is being met with ample supply.
• Wide spread on increased volume approaching a trendline means the trendline is likely to be broken.

Rising Prices: Differentiating between Real Demand and No Demand

The article wrote that “Rising prices create demand, demand does not create rising prices”. That I do not agree. IMO, rising prices create demand, and demand also creates rising prices. It is essentially this self-reinforcing loop that leads to herd behaviour and manias.

Since rising prices can be a result of mark ups, or a result of real demand, how then to tell the difference? This is where volume comes in. Rising share prices coupled with increasing volume would generally correspond with real demand, while rising share prices with low volume generally means prices are being pushed up with no real interest from buyers. Techniques of Tape Reading by Vadym Graifer wrote that rising share prices with low volume can also be due to buyers quietly accumulating. That can be true but it would have to depend on the context. If it is a stock not under any spotlight (e.g. little known company with no news), that can indeed be the case. However if it is a well-known stock or has already attracted attention, there is no such thing as “quietly” accumulating when the spotlight is already shining on it.

Interpreting Volume

So in the above paragraph, we just mentioned that rising prices with high volume is bullish. Why then does Sebastian’s article wrote that up bars with high volume are a sign of weakness? If you think about it, there are three situations that would result in up bars with high volume.

1. Situation #1: There is strong, real demand that takes out the Ask prices without meeting much resistance, with more demand coming in the near-term. This is bullish.
2. Situation #2: There is real demand that is taking out the Ask prices but the demand is a final push and has finally exhausted, with little demand coming in the near-term. This is bearish.
3. Situation #3: There is a large amount of supply that absorbs the demand and essentially caps the price at a resistance level. This is bearish.

In all situations, the daily bar that results can be an up bar with high volume. How do you tell the difference? Well the obvious way is to go one level deeper, to look at the intraday data. That will allow you to distinguish between Situation #3 vs. (Situation #1 or Situation #2). If the intraday data is still not sufficient to tell the difference, a deeper look into the time & sales may be required (e.g. are trades transacted at the bid or ask? did the bid-ask move?).

Is there a way then to distinguish between Situation #1 and Situation #2? This is when looking at only 1 single bar is insufficient. You would need to look at the flow across the time frame. If the stock continues to perform well, it was a Situation #1, else if it performed badly, it was a Situation #2. Looking at the whole flow also gives us an advantage in terms of quickly identifying a Situation #3 without going one level deeper. Generally a single up bar with a volume spike (i.e. low volume on both sides) corresponds to Situation #3. Rising stock prices with increasing volume generally corresponds to Situation #1 at the start, and Situation #2 or #3 at the end of the move.

Handling High Volume Situations

If you are still reading, you would probably be thinking that if we only know whether it was a Situation #1 vs a Situation #2 after the fact, that information is completely useless. In a sense that is true if you are looking to predict the next bar. However if you trade not by predicting moves but by taking positions as the market tells you to, then you would be fine. Simply raise your stop-loss. If it was a Situation #1, the stock continues its strong upward momentum and you are be fine. If it was a Situation #2, you get stopped out earlier and you would be fine too. Simply put, look out for high volume, and take the same action, don’t be caught up trying to interpret every single bar that you see.

-END-

Previously traders might filter data to focus on trades with large sizes to focus on “big players that move the markets”. However with modern technology, large orders are now broken down in high frequency small orders in order to mask large trades, hence a huge majority of the ticks are now concentrated in the smallest lot sizes.

One thing I’ll add here is that with HFT, one should also ignore the bid/ask volume quoted and should just look at the actual trades done, since ‘phantom volume’ is not uncommon nowadays. You might think that a large volume sitting on the bid might prevent the price from dropping or a large volume sitting on the ask might prevent the price from rising, but you would find that these volume can disappear in a heartbeat. Similarly a small volume sitting on either bid/ask can turn out to be a sponge! Long story short, ignore the bid/ask volume and only look at actual transactions.

Oh, if you are not familiar with the instruments quoted in the study (i.e. ES, NQ, YM, TF, CL, 6E, ZB), you can find a list of the symbols here: E-Trade Futures Products.

There is a good summary sentence:

In conclusion, tape reading is not watching every trade that passes by (a monotonous task) but rather keeping an eye out for unusual impulsive action, unusual volume, or just observing the way the price trades at significant levels. Each price swing has forecasting value as to what the next most immediate move should be. We then follow the price action to see if that move plays out.

Instead of being concerned with every single tick, the key is to focus on price action near specific reference points:

• Pivot points that the whole market can see
• Significant levels (e.g. S&P levels that are multiples of 10)
• Resistance/support levels
• Previous day’s high/low (look to exit profitable trades at these points in sideways markets)
• Today’s open (when the market is strongly trending)

The market tends to have continuation moves at least 2/3′s of the time when there is an impulsive action near a reference point, i.e. the market moves rapidly in a series of ticks in one direction without a tick in the opposite direction.

Another way to use tape reading is to look at price action to see the market’s response to news, compare that with what you anticipate the market should do, and make your decisions accordingly.

This book, You Can Still Make It In the Market, was written by Nicolas Darvas after his experiences in 1975, when he applied his Darvas box method again when the stock market was recovering from its crash from its peak around Jan 1973 to its bottom around Oct 1974 (S&P500 dropped ~50%).

Darvas first developed and applied his methods very successfully in the 1950s when the stock market had a good bull run from 1950 to 1960 (tripled). The question then was of course whether Darvas was successful simply due to the bull market or was it because his system works.

As  the market recovered, Darvas highlighted that there were a few stocks that rose quickly without forming boxes, which cause him to question whether his system still worked. Nonetheless he waited and his patience bore fruit when he found target stocks that formed boxes and he made his money.

The conclusion from the book is basically that the Darvas method still works, with some tweaks below:

• Change in the entry rule to look for 2 penetrations of the same box top
• Change in the initial stop loss rule, where previously it was set to 1/8 below the breakout level, now it is set to 10% below the breakout level
• Relaxation of the all-time highs rule

The Dar-Card

With the help of a graphic designer, Darvas created a visual tool called the Dar-Card, that basically shows the Darvas boxes on a chart, and a shaded danger area at the bottom of each box (i.e. the area is shaded from the bottom of the box till 5% below the bottom of the box).

Here are the Dar-Card Construction Rules

1. When the price of a rapidly rising stock reaches a resistance point which it does not surpass for 3 or more consecutive days, that point represents the top of the box.
2. If, after falling from the upper limit, the stock reaches a downward resistance point which it does not penetrate for 3 or more consecutive days, that level represents tha bottom of the box.
3. The shaded danger level is indicated when the price falls 5% below the bottom of the box.

And here are the Dar-Card Usage Rules

1. A stock is in a rising trend when it is in its topmost box. As long as it remains there its price fluctuations should be ignored and the stock is a HOLD.
2. If the price of the stock moves above the top of this topmost box the stock becomes a BUY. A 10% stop-loss should be set on the 1st breakout.
3. Having formed a new higher box, if the price falls below the bottom into the shaded area of this box the stock is SELL.
4. There is no reason to HOLD or BUY a stock that is not in its topmost box.

Change to the Automatic Buying Rule

• A penetration above the top of the box is often immediately followed by heavy selling which drops the stock a couple of points and drives it back into its previous box again. A purchase on a first penetration can therefore lead to a considerable loss.
• The reason for this behavior may be that astute professionals and floor traders know that a penetration above a resistance level is a signal for chartists to rush in and buy, so the professional traders take this opportunity to unload stock and thus make a point or two.
• In view of this, I now wait for a second penetration before buying, i.e. a penetration above the top of the topmost box, a downward reaction, and then a further rise to a new high above the first penetration’s high. [note that this is not exactly the same as penetrating the next box, since the stock can rise above the first penetration's high without forming the next box]
• If the price does not drop back after the first penetration but goes on rising I leave the stock alone; I never chase a rising stock because I never know when it will turn around and drop back again.

Target Stocks

• Avoid “widows and orphans” stocks, i.e. institutional favorites that are large and established with huge share float, which makes it difficult for their share price to double.
• Stock: Look for stocks with a promising future in new and developing industries (i.e. companies whose growth and earnings prospects look highly promising), or stocks related to some new craze.
• Industry Group: The stock should belong to a strong industry group, i.e. a group that is performing well in the market relative to other groups.
• Overall Market: The overall market should be a bull market.
• Look for
  • Sudden rises in price and volume
  • Out of the ordinary relative strength
  • Movement against the general market trend

Relaxation of the All-Time High Rule After a Bear Market

• Previously Darvas would only buy stocks making all-time highs. After the 1974 bear market, Darvas reasoned that the bear market had been so severe that all the weak holders of the stock would have abandoned it by now, hence it is fine to not wait for all-time highs.
• Essentially the whole purpose of looking for all-time highs is to ensure that there is little to no overhang preventing the stock from moving up (e.g. people holding the stock and selling at break-even as the stock moves up).
• A severe bear market will indeed kick out many of the weak holders, but I think there would still be a decent number left that are holding on and not wanting to realize the losses. Nonetheless I agree that waiting for all-time high is too high a bar after a severe bear market.

Supplement the System Rules with Tape Reading

• Case #1: National Semiconductor
  • Darvas wrote about his observations on the movements of National Semiconductor which struggled to recover after a reaction. He decided to stay out of the stock because of this struggling action.
  • That turned out to be a good call when the price dropped later and news came out on problems with their Bangkok plant.
• Case #2: Houston Oil
  • Houston oil trebled in value, then did nothing for months.
  • Darvas felt that the stock was not a strong mover, and would try to trick him into entering too soon. Hence even though the stock penetrated the top of the box, Darvas held back from entering and waited for a more positive penetration.
  • He turned out to be right and the stock dropped quickly after the penetration.
  • Darvas concluded that you must know the personality of the stock you are buying, its idiosyncrasies, its moods, its mode of behaviour.
• In both cases, Darvas did not simply follow the rules of the system mechanically but did better by reading the market action.
• Darvas was supposed to have re-read Humphrey B Neill’s Tape Reading & Market Tactics book every week. I think the personality of a stock can be gleaned by read from the tape of the stock for a period of time.

Set a Stop Loss, Minimally 20% below Highest Price

• When you buy a stock keep in the forefront of your mind, not the great killing you are going to make, but the possibility that your stock could drop 50% in value very quickly. Never ever let this happen to you. Set a stop-loss, even if only a mental one, such that you sell out any stock that has dropped 20% below its highest price.

Darvas System can be Adapted to Short Selling

• Turn the Dar-Card / Darvas System upside-down.
• Stop-loss on the top of the boxes.

Sit on the Sidelines until a Stock Satisfying Your Criteria is Available

• I have often remained liquid for as long as two years if I could find no stocks worth buying.
• I never buy a stock unless it seems likely to at least double in price in 6 to 12 months. If no such stocks come to my attention I prefer to be out of the market altogether.

Odd Bits

• On Page 27, Darvas mentioned putting in a buy order for National Semiconductor at 17.5 with a stop-loss at 14.5. The stop-loss level is not 10% below the breakout level (as specified in the Dar-Card rules), nor is it 1/8 of a point below the breakout level (as specified in his earlier books). The most likely explanation is that it is the bottom of the box.

-END-

His method is to find a stock that you believe will increase its price by 10x over the next few years.

1. Fundamental
   • Look for killer products, e.g. Crocs., try out the products yourself
   • Check that the company have new products that it can ramp out in the future.
   • Estimate the growth rate of earnings from this year to the next, based on historical trend and latest results.
   • Calculate the forward P/E ratio (using the estimated earnings growth rate to get the expected EPS) to see that it is reasonable.
   • Assume a PEG of 0.5, get the future P/E ratio, multiply that with the expected EPS  to get the future stock price.
   • The future expected stock price should be many times today’s stock price.
2. Timing
   • Use a slow stochastic, 14 days, with 3 day moving average.
   • Wait for a pullback of 20-30%, then wait to see the slow stochastic show < 20% and move upwards before you make the purchase.
3. Method of buying
   • Put all your capital into the company, don’t diversify.
   • After the price doubles, max up by buying more on margin.
   • After the price doubles again, max up with more margin again.

This looks like a high-risk strategy with no stop-loss. If you survive, yes, you can make a lot of money. If you don’t survive, well…

1. It presents simple concepts in an organized manner with lots of examples
2. There are quiz questions at the end of each chapter to test your understanding
3. It presents a complete system for trading, covering entry/exits, stop losses, etc.
4. It presents the key concepts for trading without cluttering the material with lots of nitty gritty patterns which typically just confuse readers.

One area that I felt can be beefed up more though is on money management, position sizing, and how to size continuation trades.

The trading methodology taught by Sam Weinstein is of the same style as that of Jesse Livermore and Nicolas Darvas. Basically, identify the market trend, identify strong industry groups, identify strongest individual stocks within the strong industry groups. Buy into stocks where all 3 directions (market, group, stock) are in agreement. Those criteria give you the edge, while stop losses manage the downside.

As you will read later below, Sam Weinstein uses the following 5 basic tools to analyze the individual stock.

1. Little obstacles in the stock’s path: Any nearby support/resistance
2. Performing better than the market and improving: Relative strength (relative to market, not the RSI)
3. Stock moving into an uptrend: Stage analysis using 30-week MA
4. Stock breaking out of resistance: Support and resistance using horizontal and trendlines
5. Volume confirmation: Significant increase in volume on breakouts

One problem with implementing exactly the system in the book is that a number of indicators may not be readily available on the mainstream websites or the data may not be tracked publicly. For example, the Mansfield 30-week MA uses a proprietary formula (close approximation here), the Momentum Index defined here is not plotted in any chart service, etc.

Nonetheless, the ideas in the book remain valuable and the book is definitely recommended reading for the trader starting out.

The Basics

Definitions

• Types of players
  • Trader: Catches 2 – 4 month moves
  • Investor: Catches 12 month moves
• Time frames
  • Short term: Cycles that last 1 – 6 weeks
  • Intermediate term: Cycles that last 6 weeks – 4 months
  • Long term: Cycles that last 4 – 12 months
• Pullback: Price of stock goes back close to the initial breakout / breakdown point
• Relative Strength:
  • Basic formula
    • Price of stock / Price of a market average
  • Advanced formula
    • Let X = Price of stock / Price of index
    • RS = (X / SMA(X, 52 weeks, weekly frequency) – 1) * 100
    • Essentially this variable is comparing its relative strength with the SMA of the relative strength. It is 0 if it is equal to its SMA, positive if stronger than SMA, negative if weaker.
  • AAII formula
    • AAII has a Relative Strength formula that gives a value of 0 when they are of equal strength, a positive value if the stock is stronger, and a negative value if the stock is weaker.
    • ((New stock price / Old stock price) / (New index price / Old index price) – 1) * 100

Support and Resistance

• The more times a support/resistance zone is tested, AND the longer the time period during which the testing takes place, the more important the signal when the zone is violated.

Trendlines

• A significant trendline will be touched at least 3 times.
• The steeper the trendline slope, the less meaningful is the breakout / breakdown.

Moving Average

• A 30-week MA is the best for long-term investors, and 10-week MA is the best for traders.
• These MA takes the average of the closing price of the Fridays each week, not the daily prices.
• Stocks trading below their 30-week MA should never be purchased.
• Stocks trading above their 30-week MA should never be shorted.

Breakouts / Breakdowns

• The greater the expansion of volume on the breakout, AND the longer the time spent below the resistance, the more significant it is.
• Breakdowns do not require volume to be significant, although a volume increase makes it even more significant.
• Compare the breakout / breakdown with the long-range history (over many years), it is especially favourable if it is in “virgin territory”.

Relative Strength

• Don’t consider buying the stock if the RS is in a downtrend, even if it breaks out.
• Don’t consider shorting the stock if the RS is in an uptrend, even if it breaks down.
• Watch for the RS moving from negative to positive, this is bullish. Vice versa for the other direction.
• Thomas Bulkowski did some very interesting research on relative strength. You can find the general results here, including results for industry relative strength here. His research basically supports buying stocks with rising relative strength, and industries with high relative strength. They lead both on the upside in a bull market, and on the downside in a bear market, so they are prime candidates for both the bull and bear positions.

Stages of a Major Cycle

1. Stage 1 – Basing Area
   • Volume: Usually dries up.
   • Price: Criss-crosses with the 30-week MA, usually below the MA as the MA flattens.
   • Signs of moving to Stage 2: Volume starts to expand but prices no longer moves down. Price breaks above resistance and MA with increasing volume.
   • Opportunity: Usually at least 1 pull back to near the breakout point after the initial breakout rally. This is a low-risk buy point. The reason why it is low-risk is because you would be able to see the strength of the breakout and the pull back. [if you bought your entire position at the breakout and set a stop below the resistance, there is no point buying again. If you didn't buy at the breakout or bought half your position, it may be worth considering entering here.] 
2. Stage 2 – Advancing Phase
   • Price: Maintains above the 30-week MA, with higher lows. In Stage 2, the later it is the more volatile the price swings because buyers panic more on reactions.
   • Signs of moving to Stage 3: Price starts to converge with MA.
3. Stage 3 – Top Area
   • Volume: Usually heavy.
   • Price: Choppy, criss-cross with the MA.
   • Meeting of the excited herd buyers vs. the aggressive sellers that bought at much lower prices.
   • Signs of moving to Stage 4: MA stops rising, price breaks below support.
   • Opportunity: Get Out! If you want to stay, take profits on half the position, and set a stop below the latest support level.
4. Stage 4 – Declining Phase
   • Price: Below MA, lower highs.
   • Opportunity: Get Out!

Bigger the Base, Bigger the Move

• The longer a stock is in Stage 1, the stronger the move later.
• This is because a lot of stock has changed hands many times during the extended period, including disenchanted holders that hoped to get out at break-even but finally gave up. This reduces the amount of overhead resistance.
• Stocks that have steadily risen 40-50% before breaking out do the best, rather than stocks having wide swings in Stage 1.

Overall Strategy for Both Long and Short

1. Check the market indicators for overall direction.
2. Scan the industry groups to know which ones to focus on.
3. Choose those few stocks with the most potentially profitable formations within those favourable groups.

Going Long

Criteria

• Market trend
  • Bullish
• Industry group
  • Bullish, look for industry group breaking out from Stage 1 to 2, or already in Stage 2, with minimum resistance overhead.
  • Stocks having the same bullish chart, may perform very well in a bullish group but so-so in a bearish group.
• Individual stock
  • Overhead resistance: Preferably no nearby overhead resistance, clear blue skies are the best!
  • Price: Breaks out above resistance.
  • Stage: Going from Stage 1 to 2. Price above 30-week MA. MA flat or increasing. Beware of buying too late in Stage 2.
  • Relative strength: Trending higher. If crosses from -ve to +ve, even better.
  • Volume: Significant increase on breakout. Volume on breakout day at least 2x the average volume of the prior week, or one-week volume spike at least 2x the average volume of the past month, or volume over the past 3-4 weeks at least 2x the average volume of the past several weeks with some increase on the breakout week.

Buying Pullbacks

• After a strong breakout, if the price pulls back closer to the MA, with volume significantly contracting, that is another good entry point.

Continuation Buys

• Only if a consolidation pattern forms above the increasing MA and then a new breakout occurs.

Buy Orders

• Use a buy-stop-limit good-’til-cancelled order, the stop is set 1/8 above the breakout level, the limit is set 1/4 above the stop.
• If volume is favourable on the breakout and contracts on the decline, buy your other half position on a pullback toward the initial breakout.
• If volume is not significant on breakout, sell the stock on the first rally, or sell when it breaks below the breakout level.

Stop Loss Orders

• Use a sell-stop good-’til-cancelled order if trading on a liquid exchange / stock. This will turn into a market order and not a limit order. You want out and can’t be choosy.
• For OTC markets with low liquidity, get a broker that can implement it manually.
• If the sell-stop is near a round number, set it just under the round number, because people like to put buy orders at round numbers. This works for halves as well, especially for prices under $20 (e.g. $16.50).
• For Investors
  • First sell-stop set below the bottom of the trading range (just below support).
  • When the next support level is determined, raise the sell-stop to just below the MA point that was below the new support level. If the support level is below the MA, set the sell-stop just below the support level.
  • When the MA stops rising and flattens out (i.e. Stage 3 top is forming), raise the sell-stop to just below the most recent support level.
• For Traders
  • Breakouts that are going to be big winners almost never pull back more than 4-6% below the breakout point.
  • Set the initial stop under the closest support level, or 4-6% below the breakout level.
  • When the next support level is determined, raise sell-stop to just below the support level. Ignore corrections of less than 7% when determining support.
  • When the MA stops rising and flattens out (i.e. Stage 3 top is forming), raise the sell-stop to just below the most recent support level.
  • If there is a valid trendline (3 points), you can raise the sell-stop for half your position to just below the trendline during the period before the next support level has been determined (hence the sell-stop can change day-to-day following the trendline). The sell-stop for the other half of your position remains at the sell-stop set at the previous support. When the next support is found, raise the sell-stop for the full position to just below the support found.

Going Short

Criteria

• Market trend
  • Bearish
• Industry group
  • Bearish, look for industry groups that have broken below their 30-week MA, going from Stage 3 to Stage 4.
• Individual stock
  • Support below: Preferably no nearby support below.
  • Price: Breaks down below support.
  • Stage: Had a strong Stage 2 advance, preferably with little stopping along the way (which creates support which is bad for shorting). Going from Stage 3 to 4. Price below 30-week MA. MA flat or decreasing.
  • Relative strength: Trending lower. If crosses from +ve to -ve, even better.
  • Volume: Not important, but if volume increases, that makes it even more negative.

Shorting Pullbacks

• Don’t wait for pullbacks to short, because stocks typically drop down fast and seldom pulls back.

Continuation Shorts

• Only if a consolidation pattern forms below the declining MA and then a new breakdown occurs.

Sell Orders

• Use a sell-stop-limit good-’til-cancelled order, the stop is set 1/8 below the breakdown level, the limit is set 1/2 below the stop (its 1/2 for the short instead of 1/4 for the long because of the uptick rule, since the stock will have to go up first, that increases the risk of shorting, so a 1/2 is used to ensure that the stock drops down more convincingly).

Stop Loss Orders

• Use a buy-stop good-’til-cancelled order if trading on a liquid exchange / stock. This will turn into a market order and not a limit order. You want out and can’t be choosy.
• If the buy-stop is near a round number, set it just above the round number, because people like to put sell orders at round numbers. This works for halves as well, especially for prices under $20 (e.g. $16.50).
• For Investors
  • First buy-stop set above the top of the trading range (just above resistance), should not be too far (30-40% is no-no) away.
  • When the next resistance level is determined, lower the buy-stop to just below the MA point that was above the new resistance level. If the resistance level is above the MA, set the buy-stop just above that resistance level.
  • When the MA stops declining and flattens out (i.e. Stage 1 base is forming), lower the buy-stop to just above the most recent resistance level.
• For Traders
  • NEVER stay with a short position that moves above its 30-week MA, even momentarily.
  • If there is a prior peak very close to the breakdown level, use that as the initial buy-stop. Else, set the initial buy-stop 4-6% above the breakdown level.
  • When the next resistance level is determined, lower buy-stop to just above the resistance level. Ignore oversold rallies of less than 7% when determining resistance.
  • When the MA stops declining and flattens out (i.e. Stage 1 base is forming), lower the buy-stop to just above the most recent resistance level.
  • If there is a valid trendline (3 points), you can lower the buy-stop for half your position to just above the trendline during the period before the next resistance level has been determined (hence the buy-stop can change day-to-day following the trendline). The buy-stop for the other half of your position remains at the buy-stop set at the previous resistance. When the next resistance is found, lower the buy-stop for the full position to just above the resistance found.

Diversification

• 5-6 stocks for a small portfolio ($10,000 to $25,000)
• 10-20 stocks for a larger portfolio (>$100,000)
• Diversify across industry groups if possible.

Theories Best To Be Ignored

• To move from Stage 1 to Stage 2, the price should go down with a spike in volume to show final panic dumping, followed by a shrinking of volume to show lessening selling pressure.
• Volume is not a good indicator of future upside potential for head-and-shoulder bottoms.

Patterns

Four-year Presidential Cycle

• Election Year: +ve
• Election Year + 1: -ve
• Election Year + 2: -ve 1st half, recovery in 2nd half
• Election Year + 3: +ve

Days of the Week

• Mon: Worst, -ve
• Tue-Thu: +ve
• Fri: Best, +ve

Swing Rule

• Swing Up
  • A = Peak price (i.e. resistance level) made just before an important decline sets in
  • B = The next low price (i.e. support level) at the bottom of the important decline.
  • After the stock recovers and moves past price A, the near-term target price is A + (A – B), i.e. the height from A to B is projected upwards from A.
• Swing Down
  • A = Support price made just before it shoots up.
  • B = Peak price reached by the stock before it drops down below A.
  • The near-term target price will be A – (B – A), i.e. height from A to B is projected downwards from A.

Head and Shoulder Top

• Volume is usually lighter on the right shoulder rally. Don’t trust the formation if the heaviest volume appears on the right shoulder, because if that much buying power is still present, there is a high probability that the formation will prove a short seller’s trap.
• The bigger the top (from neckline to peak), and the longer the formation takes to form (hence trapping more buyers that will contribute by panic selling later), the bigger the drop.

Long-Term Indicators

Stage Analysis

• Track the 30-week Simple Moving Average of the Index with weekly closing prices to determine the market’s Stage.

Advance-Decline Line

• Change in the A-D line = Previous A-D line value + no. of advancing issues – no. of declining issues
• Signs of a new bear market
  • Non-confirmation: New high on the Index without a corresponding new high on the A-D line.
  • Negative divergence: Index charges ahead but the A-D line loses upside momentum.
  • A-D line will peak first because money moves from secondary stocks into higher-quality blue chips (no. of blue chips is less than no. of secondary stocks), so Index will continue moving up while A-D stops rising.
  • NYSE A-D line reaches its ultimate peak 5-10 months before the blue chips top out.
• Signs of a new bull market
  • Positive divergence: Index reaches ultimate low, but A-D line continues to move lower.
  • Index refusing to drop further shows some sectors are shaping up even while others continue to go down. Buyers initially gravitate toward the quality issues while shunning the more speculative ones.

Momentum Index (MI)

• Calculate each day’s NYSE advance-decline figures, i.e. value = no. of advances – no. of declines (this is not the same as the A-D line)
• Momentum Index (MI) = 200-day moving average of each day’s value (this will fluctuate around zero)
• Important signals
  • Crossing of the zero line in either direction.
  • The longer the indicator has been deep in +ve/-ve territory, the more significant the move when it crosses the zero line.
  • In a bull market, the MI will almost always reach its peak before the Index does.
  • In a bear market, the MI are somewhat late in signalling, and acts more as a confirming signal.

New Highs and New Lows

• Track the number of new highs and new lows of common stock (exclude preferreds) on a weekly basis.
• High-Low Differential (HLD) = No. of new highs – No. of new lows
• Important signals
  • If the HLD is consistently positive, that is favorable.
  • If the HLD is consistent negative, that is unhealthy.
  • Positive divergence: Index trends down while the HLD trends up. HLD shows subsurface technical strengthening.
  • Negative divergence: Index trends up while HLD trends down. Tipping off a bear market.

International Stock Markets

• The most profitable moves occur when the overwhelming majority of world markets are in agreement.

Dominant Listed Company

• At that time, General Motors (GM) was dominant.
• Apply Stage Analysis to GM.
• If GM does not make a new high (or low) within 4 months, it is a signal that GM’s prevailing trend is reversing. If this does not agree with Stage Analysis, stick with Stage Analysis.
• GM’s change in trend is an early signal for the market.

Price / Dividend Ratio

• Calculate the price/dividend ratio for the Index.
• Ratio above 26 is dangerous, above 30 means stocks are extremely overvalued.
• Ratio declining towards the 14 to 17 area means stocks are undervalued.
• This needs to be used as a confirming indicator in conjunction with other timing gauges.

The Financial Press (Contrary Opinion)

• Markets top out on good news, and hit bottom on bad news.
• Leading financial magazines / newspapers tend to show cover stories and headlines, opposite of what is going to happen, near the peak or bottoms.

Playing Other Instruments

Funds

• Stage analysis can be used to switch in and out of mutual funds.
• Traders may want to use a 30-day MA instead of a 30-week MA.

Options

• Buy a call option only on a stock that is in Stage 2 or is moving into Stage 2. Buy a put option only a stock that is in Stage 4 or is moving into Stage 4.
• Selectivity is crucial. Buy an option only on a stock that has a tremendous potential. You need to only buy on an A+ situation. For stocks, you can be right must less than 50% of the time and still make money. For options, you need to swing only at the best pitches.
• Ideally have options ~3 months from expiration, never less than 45-50 days.
• Buy an option that is close to the strike, and if possible, slightly in the money. This is to strike a balance between wanting leverage and high returns (i.e. out-of-money options), and being too safe with lower reward/risk (i.e. deep-in-the-money options).
• Use a very tight protective stop that is tighter than for stocks. Stop-loss orders are not appropriate because of the illiquid market.

-END-

The two books are

1. How I Made $2,000,000 in the Stock Market (1994, first published 1960); and
2. Wall Street: The Other Las Vegas (2008, first published 1964)

Darvas was a full-time professional dancer who travelled around the world with his partner to, well, dance. He did his trading mostly through cablegrams. He asked his brokers to send to him daily quotes on stocks he was interested in and weekly Barron’s stock tables. He then sends instructions to his brokers with his on-stop buy orders and corresponding stop loss orders. He managed to turn around $50,000 to more than $2,000,000. He started trading in 1953, started using his Box Theory in 1956, achieved $2,000,000 by the end of 1959.

The first book, “How I Made $2,000,000 in the Stock Market” is a very good read for the story. In terms of the exact rules of the box, you would get that from “Wall Street: The Other Las Vegas”, with clarifications in a Q&A section at the back of the “How I Made $2,000,000 in the Stock Market”. The story bit in “Wall Street: The Other Las Vegas” is much worse than the first book so I would recommend that you read the first book followed by the second book, then going back to the Q&A section in the first book.

Darvas later had a few other books, including “You Can Still Make It In The Market” where he applied his method through the bear market in the 1970s, and ”Darvas System for Over the Counter Profits“, but I have not had the chance to read those [I have just read 1st of these two books where there were some updates in the system rules. You can find the book review here: Book Review of You Can Still Make It In The Market by Nicolas Darvas.].

Darvas’ system is basically one that identifies support and resistance levels using mechanical rules, and buys into stocks trading at all-time highs with increased volume and breaking resistance levels, selling when they drop below support levels. The system is simple, clear, and easily implementable. One thing to note though, it is best to learn straight from the source (i.e. read the books), because some of the materials on the net may not present the Darvas method accurately.

Difference Between Darvas’ and Livermore’s Methods

Note that Darvas’ original system works best in a bull market where there are indeed a number of stocks making all-time highs. It was also not designed to be used to play the short side in a downtrend.

In contrast, Livermore goes for the leading stocks in the leading sectors, in the direction of the overall market trend. Jesse Livermore’s method is meant to be applied to both bull and bear markets, on the most active stocks in the strongest industries. Support and resistance (Darvas calls them the bottom and top of the box, while Livermore calls them pivotal points) are used to identify trend turning points.

Darvas’ method uses support and resistance to identify breakouts of stocks that have something special going on with them (i.e. sudden investor interest). The target stocks are different, and the trading approach taken is also different.

Overall, both books are definitely recommended! They are short books which can be read quickly, the idea is straightforward, and the story in the first book is great.

Key Points

Darvas’ Learning Journey

1. Canadian period
   • Lost money gambling in the Canadian market from tips, rumours, and nice sounding company names.
   • Lost money following financial advisory services and brokers’ tips.
2. New York period
   • Read up on investment books, daily papers, financial columns, subscribed to stock market services (Moody’s, Fitch, S&P).
   • Pored through financial statements of companies, analyzed their fundamentals.
   • Lost money on stocks with supposedly very good fundamentals.
   • Lost money picking stocks based on things like top quality ratings, selling below book value, strong cash position, never cut their dividends, stocks experts like, price earnings ratio, profit margins, industry outlook, choosing the strongest company within the strongest industry group, researching comparable companies, comparing earnings growth of different industry groups, etc.
   • Lost money selling too early for little gains and losses from jumping in and out of losing stocks.
   • Lost money trading in the OTC market due to the huge bid-ask spreads.
   • Lost money listening to more broker’s tips.
   • Lost money following insiders. Insiders are human too, they often bought too late or sold too soon. They might know all about their company but they did not know about the attitude of the market which their stock is sold.
   • Finally got saved with a stock that he bought simply because it was rising (Texas Gulf Producing).
3. [My note]
   • While it seemed like all the things that Darvas tried did not work, I am not convinced that Darvas did some of the methods correctly.
   • The fundamental research that Darvas did seemed too superficial and did not go in-depth into the analysis of critical points such as business model, competitive dynamics, return on invested capital, free cash flow, etc.
   • Similarly, Jesse Livermore did well with strongest stock in the strongest industry, but when Darvas tried it, he picked the cheapest stock in the strongest industry (Jones & Laughlin) even though he called it the strongest stock, probably because he thought the “best bargain” is the strongest.

Darvas’ Discoveries

• Stocks trend
  • I started to realize that stock movements were not completely haphazard. Stocks did not fly like balloons in any direction. As if attracted by a magnet, they had a defined upward or downward trend which once established, tended to continue.
  • … contrary to my impression, stocks behaved with a certain consistency, following upward or downward trends, which made it possible to foresee what they were likely to do on the basis of what they actually were doing.
  • I saw reasons for this; buying tended to generate more buying and progressively higher prices. Conversely, selling at a given price soon exhausts the supply of buyers available at that price, and forces offerings at a lower price — and this process, too, tends to be progressive.
• Stocks move from Box to Box
  • Within this trend stocks moved in a series of frames, or what I began to call “boxes”.
  • They would oscillate fairly consistently between a low and a high point. The area which enclosed the up-and-down movement represented the box or frame.
  • … the entire upward progress of the stock in question had consisted of movements of a similar sort – a progression from one box to another, each stage in the development of the stock being marked by a period of oscillation between clearly discernible limits, then a breakthrough, and a new period of bouncing up and down in the next box, and so on.
• Stocks in an industry group move together
  • It seemed to me, listening to such reports and studying them in the Wall Street Journal, that this was the way the market moved, first one group gaining, then another pushing to the top, like schools of dolphins surfacing one at a time.
• An edge is required
  • There is no sure thing in the market — I was bound to be wrong half of the time.
  • I knew that being right half of the time was not the answer to success. I began to understand how I could break even and still go broke. There was only one answer to this danger: My profits had to  be bigger than my losses.
• Stop loss is required to stop big losses and keep profits
  • The task was to define the frame exactly and be sure the stock did not move decisively below the lower edge of the box. If it did, I sold it at once, because it was not acting right.
  • I decided to give “on stop” orders to buy at a certain figure with an automatic “stop-loss” order on them in case the stock went down. This way, I figured, I would never sleep with a loss. If any of my stocks went below the price I thought they should, I would not own them when I went to bed that night.
  • I knew that many times I would be “stopped out” for the sake of a point just to see my stock climb up immediately after. But I realized that this was not so important as stopping the big losses.
  • I always sold too quickly because I am a coward [afraid that the gains will disappear]. I decided that since I could not train myself not to get scared every time, it was better to adopt another method. This was to hold on to a rising stock but, at the same time, keep raising my stop-loss order parallel with its rise.
• Stop loss foretells market turning points
  • If you find your automatic stop loss selling you out of everything, and the stocks you are watching are not moving towards higher boxes, then it is a signal that the market has changed.
• Companies with rising earnings trends are less affected in any market downturn.
  • I would select stocks on their technical action in the market, but I would only buy them when I could give improving earning power as my fundamental reason for doing so. [Darvas' techno-fundamentalist theory]
  • … I looked out for those stocks which were tied up with the future and where I could expect that revolutionary new products would sharply improve the company’s earnings.
  • But I did want to know whether the company belonged to a new vigorous infant industry and whether it behaved in the market according to my requirements.
  • … I was constantly searching for the stocks that would climb into the stratosphere because of the vision of their future.
• Buy more as the stock goes higher
  • Darvas usually built his position over 3-5 purchases.
  • The first purchase usually is a smaller purchase, followed by the rest of the purchases roughly of equal size (in terms of number of shares).
• Volatility within the Box is good
  • While it stayed within its box, I considered a reaction from 55 to 50 as quite normal. It did not mean to me that the stock was going to fall back. Just the contrary.
  • It shakes out the weak and frightened stock holders who mistake this reaction for a drop, and enables the stock to advance more rapidly.
• Limit your losses by both amount and time
  • By amount: I have discovered no loss-free Nirvana. But I have been able to limit my losses, without compromise, to less than 10% whereever possible.
  • By time: Profits are a function of time, and so good reasons have to exist to keep a profitless purchase longer than 3 weeks.
• Watch the Market
  • From then on, I made up my mind to keep watching the Dow-Jones Industrial Average, but only in order to determine whether I was in a strong or a weak market.
  • This I did because I realized that a general market cycle influences almost every stock. The main cycles like a bear or a bull market usually creep into the majority of them.
  • By my practice, I found that my methods were best suited to the sort of market in which the greatest opportunity for selection over a wide range of rapidly rising stocks existed — and that, of course, meant a strong bull market.
• Keep a trade journal
  • Whenever I bought a stock, I wrote down my reason for doing so [and the price]. I did the same when I sold it.
  • Whenever a trade ended with a loss, I wrote down the reason I thought caused it. Then I tried not to repeat the same mistake.
• Stick with friendly stocks
  • I started to see that stocks have characters just like people. Some of them are calm, slow, conservative. Others are jumpy, nervous, tense.
  • And some of them I could not handle. Each time I bought them they did me an injury.
  • I began to take the view that if these stocks slapped me twice I would refuse to touch them any more. I would just shake off the blow and go away to buy something I could handle better.
• How to choose among short-listed stocks
  • Let the market decide which of the stocks are strong / weak.
  • Enter a small position in each of the stocks. Put a stop loss of 10% below buying price.
  • The stocks that get stopped out are discarded.
• Avoid fallen champions
  • A stock which was formerly a champion, selling at, say 150, may look like a bargain if it is currently on the market at 40 and gaining ground.
  • But I also figured that it is coming from behind, and thus laboring at a terrific handicap. To have slipped back from 150 to 40 means to have inevitably inflicted serious losses on all the traders who bought i at or near the peak and were later forced to sell at lower prices.
  • Thus there is certain to be strong psychological resistance to overcome, much ground to regain, before such a stock will again begin to look like a winner.
  • … I came to the conclusion that the only stocks which would be of real interest to me would be those that were breaking all previous records: stocks not merely rising in price, but actually in their highest boxes ever.

Darvas’ Principal Philosophy

• My only sound reason for buying a stock is that it is rising in price.
• If that is happening, no other reason is required.
• If that is not happening, no other reason is worth considering.

Darvas Box System Rules

Required Elements

• All-time high of the stock
• High and low for the past 2-3 years
• Weekly price range and volume for at least the last 4-6 months

Routine

1. Check general market trend as indicated by market averages
2. Examine 6-8 stocks of each of the 3-4 industries that he was interested in, to see how the industries behave in relation to the general trend of the market.
3. Examine the price changes in stocks he held and stocks he was interested in.
4. Review the stock page to see unusual price and volume changes for possible new candidates.

Short-listing Process (Techno-Fundamentalist approach)

• Price
  1. First stage filter – Short-list stocks where
     1. The high for the year is at least double the low for the year; AND
     2. The stock’s high for the week is at or within a few points of the high for the year.
  2. Second stage filter – Short-list stocks that were at their historical peaks.
• Volume
  • Stocks showing remarkably increased volume in a stock in which trading had been relatively quiet.
• Fundamentals
  • Capitalization: Volume of trading activity is large compared to the number of common shares outstanding [my note: comparing volume with shares float would be more accurate.]
  • Expected Earnings: Stocks with the greatest expectation of increasing earnings.
  • Industry Group: Stock is in an infant industry where earnings could double or treble, not in a static or dying industry.

Target Stocks

• A usually inactive stock which suddenly becomes active (volume should at least double), coupled with an advance in price.
• Stocks making new historical highs, not just highs over a lesser period (e.g. 5 years).
• Price keeps moving upwards with volume consistently high.
• It should be a lively stock, else it would probably not rise dynamically.
• It should move into a higher box. If it fell into a lower box, it is not behaving correctly and should be eliminated.

Establishing the Top and Bottom of Boxes

• The top of a box is established when the stock does not touch or penetrate a previously set new high for three consecutive days.
• The bottom of a box is established when the stock does not touch or penetrate a previously set new low for three consecutive days.
• The bottom of a box can only be established after the top of a box is established. The bottom can be established in the same day when the top was established.

Placing Orders

• On-stop purchase order is placed 1/8 above the top of the box, with a stop-loss order placed 1/8 below the top of the box.
• Keep the stop-loss order at its previous level until the stock had established the upper and lower level of its new box. Then raise the previous stop-loss order to 1/8 under the lower limit of the new box.
• Where the historic high is above a box high, the on-stop purchase order is set 1/8 above the historic high, and the stop-loss order is set 1/8 below the historic high.
• [My notes: When to Buy]
  • The above is the “official” rules from the books, however in page 71 of “How I Made $2,000,000 in the Stock Market”, Darvas did the following trades: Bought Baltimore & Ohio Railroad at 56.25 thinking that it was in the 56/61 box, bought Dobeckmun at 45 thinking that it was in a 44/49 box, bought Foster Wheeler at 61.75 thinking that it was in the 60/80 box.
  • Since Darvas does not predict stock prices, it is somewhat puzzling as to how he came up with the expected box tops of 61, 49, and 80 in the examples above.
  • One explanation could be that the box was formed and he bought it near the bottom of the box thinking that it would advance, hence the language use of “thinking that it was in the XX/YY box”.
• [My notes: Where to set Stop-loss]
  • While the book had the initial stop-loss placed 1/8 below the top of the box, in one of the Q&As on whether the stop-loss is too close, Darvas replied that the stop losses were placed either immediately following a massive breakthrough on the up side (in which case the stop-loss was placed just below the breakthrough point) or; a fraction below the bottom of a box.
  • It is not clear whether if a normal breakthrough (not a massive one) would work as well.
  • If you buy when the next box bottom (after breakout) is formed, you can have a good situation where the initial stop-loss is near.
  • This is assuming that the time distance between the breakout and the formation of the next box bottom is short. If the time distance is short, the chance that it will continue to break through the current box top is still good, so entry at the formation of the box bottom is fine.
  • However if the time distance is long, or the vertical price distance is long, the chance that it will break through the current box top can be significantly diminished. In this situation it is better to not take the risk, and wait for a situation where the distances are short.
  • One situation is where the breakout is particularly strong, e.g. stock shoots up by 15% due to some good news. If you want to buy on breakout, the initial stop loss should be set at the low made on the day the stock broke out, because the box top that was just broken would be too far away. In the situation where this particularly strong breakout coincides with the formation of the box bottom (after a previous breakout), the initial stop loss should also be set at the low made on the day the stock broke out, instead of the box bottom just made.

Modern Adaptation of Darvas Box by Daryl Guppy

Changes in Trading Situation from Darvas’ Time

• Higher volumes
• Higher volatility

Target Stocks

• Stocks making new high for the rolling 12- or 6-month period.

Basic Orders

• Buy order placed for the following day when the High or Close today exceeds the top of the Darvas box. This is because intra-day volatility tends to create false signals.
• Sell order placed for the following day when the Close today drops below the Darvas stop-loss point. While there is a chance that the stock can drop quickly, most likely you would be able to sell at the same Close price the following day. The benefit of this change is that it substantially reduces the number of false exit signals due to intra-day volatility.

Variation of Entry Rules

• Aggressive entry
  • After a box is formed, buy close to the bottom of the box, with a stop loss at the bottom of the box, in anticipation of a breakout.
  • This aims to capture more of the upside by buying early close to the support level (i.e. bottom of the box).
  • [My thoughts]
    • A precise rule wasn’t given, so I would think that buying immediately after the bottom of a box has been identified would be a good implementation of this rule because that is as “close” (time-wise) to the bottom of the box that you can get, and since you don’t predict the stock price movement, that point is as good as any others.
    • In addition, it would have been a point where the low is above the lowest low in the past 3 days, implying that it would have been a positive / neutral day. People tend to think that the market will go up the next day if the previous day was positive, so that would be a positive reason to using that as the buy point.
• Delayed entry
  • After there is a breakout of the top of a box, wait for a pullback that goes back into the box towards the bottom of the box.
  • Then buy close to the bottom of the box, with a stop loss at the bottom of the box, in anticipation of a reversal and move into a higher box.
  • [My thoughts]
    • This may be a good method to handle overlapping Darvas boxes, basically to buy when the bottom of the next Darvas box is formed. 
    • The benefit of this is that you solve the problem of being stopped out each time the next box’s bottom is below the box top you used to initiate the buy, which can result in accumulating losses even though the stock is trending up. 
    • The problem is solved because the stop loss is at the bottom of the box, hence so long as the bottom of the next box is higher, you don’t get stopped out. 
    • Essentially you have shifted the comparison to between the ‘bottoms’, versus comparing between the top (used to initiate the position) and bottom of the next box. 
    • The disadvantage of this is that stocks with overlapping Darvas boxes do mean that the strength of the up move is not that strong. So you are essentially playing with a weaker stock, and changing the system to fit this weaker stock.
    • For Darvas, note that only the first comparison is between the top and bottom, if a stock passes the initial test (i.e. showing that the stock is strong), thereafter the comparisons will be between bottoms.
    • Another potential way to deal with this is to increase the number of days from 3 to say 5 – 7. That will filter out more non-significant resistance and support, and does increase the vertical distance between boxes (i.e. less chance of overlapping boxes).
    • Of course, another potential is to do both, increase the window and buy at the bottoms.]

Variation for Trading Breakouts on Reversal (Breakout Darvas)

• After the breakout of a downtrend (i.e. reversal), initiate the trade after the formation and breakout of the 2nd Darvas box.

Handling Gap Ups of Darvas Boxes

• There is a problem when a stock breaks outs of a Darvas box, and moves up significantly without forming another Darvas box, because the stop loss point would still be at the bottom of the previous Darvas box, which would be a long way down.
• To protect profits in such a situation, imagine “Ghost Boxes” that stack on top of the previous Darvas box, with the same height as the previous Darvas box.
• Such Ghost Boxes are actualized when the stock price moves above the top of a Ghost Box. The stop loss is then raised to the bottom of these Ghost Boxes.
• Hence when the first Ghost Box is created (after the stock price exceeds the top of this Ghost Box), the stop loss will essentially be raised to the top of the previous Darvas box.
• Subsequent Ghost Boxes being created will also mean that the stop loss will get raised to the top of the previous Ghost Box.

-END-

• IAS 33: Earnings Per Share

Basic Earnings Per Share (EPS)

Formula

• Earnings Per Share (EPS) = Profit / (loss) attributable to ordinary shareholders / Weighted average number of shares outstanding over the period
• For Consolidated accounts, EPS is calculated based on the profits attributable to the owners of the Parent.
• Weighted average number of shares mean the number of shares outstanding are weighted by the time they are in outstanding in the year.
• If there are any shares that are not fully paid-in, the amount paid-in is used to determine the number of fully-paid shares that would result in an equivalent amount paid-in. That number of fully-paid shares is used in the weighted average computation.

EPS and Bonus Shares Issue

• EPS for both the current year and previous year are calculated as if the bonus shares were issued at the start of the year. It is to ensure comparability of the EPS with the previous year.
• Comparable EPS for previous year = Original EPS for previous year * No. of shares before bonus issue / No. of shares after bonus issue

Rights Offering

• Shareholders get one right for each share of stock they own. They will need to give up a specified number of rights + subscription price of a new share, in order to get a new share.
• Actual Cum Rights Price (ACRP or CRAP) = Market price of the stock just before the rights offering expire
• Theoretical ex-rights price (TERP) = (No. of rights for 1 new share * CRAP + subscription price) / (1 + No. of rights for 1 new share)
• The way to think about this is to consider that after a rights holder exercises his rights (e.g. 2 rights for 1 new share, CRAP = 20, subscription price = 10), he will end up 3 shares with total value of 2*20 + 1*10 = 50.
• The value each share is then 50 / 3 = 16.67, which is the TERP.
• Value of 1 right = CRAP - TERP

EPS and Rights Issue

• Share count for the portion of the year before the new shares (from the rights offering) were issued is adjusted by a factor of CRAP / TERP. Hence if the rights offering is the only shares transaction, the number of shares for current year’s EPS = Number of Shares before Rights Issue * CRAP / TERP
• Comparable EPS for previous year = Original EPS for previous year * TERP / CRAP

Diluted EPS

Calculating Weighted Average Number of Shares

• Assume that the potential ordinary shares are converted at the beginning of the period or the instrument’s issue date, whichever is later.

Convertible Preference Shares & Convertible Bonds

• Numerator
• For Preference Shares, dividend needs to be removed from income statement, so earnings is higher.
• For Convertible Bonds, interest cost (and interest tax shield) needs to be removed from income statement, so earnings is higher.
• Denominator
• To calculate the weighted average no. of shares, assume that the potential ordinary shares are converted at the beginning of the period or the instrument’s issue date, whichever is later.
• If there are multiple conversion rates to common, choose the most dilutive one.
• Diluted EPS must only incorporate conversions that are dilutive. If a conversion is accretive, that instrument is ignored in the Diluted EPS computation.

Share Options and Warrants

• Treasury Stock Method
• Calculate the number of shares that will be issued if all options/warrants are exercised.
• Subtract away the number of shares that can be purchased (using average market price over the period) with the proceeds from the options/warrants exercise. This assumes that the cash proceeds from exercise will be used to repurchase shares to mitigate the dilution.
• That is the additional number of shares for the Diluted EPS denominator.

Contingently-issuable Shares

• These are shares issued if certain conditions are met, e.g. employee performance targets.
• If the conditions are satisfied already, assume that the shares have been issued since the beginning of the period, else assume that no shares issued.

Employee Share Option Plans, Performance Share Plans, Restricted Share Plans

• If there is a performance condition, account for it as contingently-issuable shares.
• Else, account for them as per the rules above, assuming that any vesting conditions are satisfied.

Incorporating Dilution from Multiple Sources

1. Rank each instrument, from most dilutive to least dilutive (individual effect)
2. Start by incorporating the most dilutive instrument first into the Diluted EPS computation, and do that one after the other for the instruments down the ranking.
3. Pick the “most diluted” (i.e. lowest) Diluted EPS figure.

Handling Negative Earnings Per Share

• If EPS is negative, dilution in this case still means making the EPS worse, i.e. even more negative.
• Instruments are incorporated in the Diluted EPS computation only if they are dilutive, and not accretive.
• The methods above would still apply.

-END-

To eliminate 3 issues that prevent a distressed company from recovering

1. Negative retained earnings
• Companies with accumulated losses are not allowed to pay dividends. One reason is that it prevents the shareholders from withdrawing money and leaving the debt holders high and dry.
• This discourages potential investors from investing in the company.
• The company will find it difficult to obtain debt financing as well.
2. Overdue interest and debt
• Distressed companies are cash strapped. Needing to pay interest puts burden on the company, and prevents it from committing necessary capital to turn around the business.
• The debt and interest also results in high gearing and low interest coverage ratios, which again prevents the company from obtaining additional debt financing.
3. Overdue dividends on cumulative preference shares
• Same reasons as per debt, since preference shares are essentially debt.

Types of Entity Construction Schemes (accounting speak)

1. Capital reduction
2. Reconstruction
3. Liquidation via a new company

Capital Reduction Scheme

This addresses the 1st point above. A capital reduction scheme essentially recognises the loss that the equity holders have incurred by adjusting equity reserve accounts. A company

• Resets any negative retained earnings account by offsetting it with equity reserve accounts (e.g. share premium account first, followed by share capital account)
• Writes off any unpaid share capital by reducing the value of its share capital and restating as fully paid shares.
• Writes off share capital not backed by available assets (e.g. reducing intangibles and share capital)

Since this would allow equity holders to pay themselves dividends again, court approval is typically required so as to take into account the interests of other stakeholders (e.g. debt holders).

Reconstruction Schemes

This addresses the 2nd and 3rd points above. This involves the company

• Writing off overdue debt interest and restructuring debt to have lower interest and extended maturity
• Writing off cumulative preference shares dividend owed
• Writing off amounts owed to suppliers
• Issuing new shares (crediting equity reserves) to the previous debt holders, preference shares holders, suppliers for accepting to restructure the debts.

Essentially debt holders convert to being equity holders, possibly retaining a lower debt amount. This allows them to recover their funds through the company’s recovery, as opposed to not recovering their funds when the company collapses.

Liquidation via a New Company

This involves:

• Selling assets to another company
• Using the proceeds to pay down remaining debts, and liquidating the business.

Accounting

• Profit recognised is based on proceeds less carrying costs of remaining net assets.
• The buyer of the assets will still recognise Goodwill based on the fair value of the assets bought.

-END-

• IFRS 1: First-Time Adoption of International Financial Reporting Standards

Overview

• Must comply with all IFRS.
• Partial compliance or a reconciliation from local GAAP to IFRS is not sufficient.
• Prepared on the basis as though the entity had always applied IFRS.

Key Dates

• First reporting date
• Reporting date of the financial statements for the first time IFRS is adopted, e.g. 31 December 20X1.
• Transition Date
• Since the previous year’s results must also be shown, effectively the company needs to apply IFRS for the previous period.
• The transition date is then the beginning date of the previous period, e.g. 1 January 20X0.

Transition Process

• Identify relevant IFRS standards
• De-recognise assets and liabilities not allowed under IFRS
• Recognise new assets and liabilities allowed under IFRS
• Reclassify assets, liabilities and equity per IFRS rules.
• Re-measure items based on IFRS rules.

Optional Exemptions

• Business combinations
• Accounting for previous business combinations can be retained. Impairment test needs to be done for the goodwill.
• Non-current assets
• Fair values under previous GAAP can be used as the “cost” under the IFRS cost model.
• Foreign currency translation
• Translation reserve can be transferred into retained earnings.
• Actuarial gains/losses on employee benefits
• All actuarial gains/losses can be recognised at the beginning of the current reporting period.

• IAS 2: Inventories

Types of Inventories

• Finished goods
• Work-in-progress
• Raw materials

Valuation of Inventories

Inventories are valued at lower of

• Cost; and
• Cost = Cost of purchase + cost of conversion + other costs to bring the inventories to their present location and condition
• Cost of purchase = Cost of purchase – trade discounts
• Cost of conversion = Direct costs (labour and expenses) + Indirect costs (share of production overheads)
• Other costs = Import duties + transport costs + other handling costs
• Net realisable value (NRV)
• NRV = Estimated selling price – estimated cost to complete the item for sale – estimated cost to make the sale

Measuring the Cost of Goods Sold (from Inventories)

• Actual cost is used if items sold can be individually identified, else either FIFO (First-In-First-Out) or AVCO (Weighted Average Cost) is used.
• LIFO (Last-In-First-Out) is no longer allowed.

Accounting for Write-downs

• Expense recognised in P&L.
• Cr Inventory, Dr Inventory Write-down Expense

-END-

• IAS 12: Income Taxes

Basics of Current Tax and Deferred Tax

Current Tax

• Difference between Tax Expense in Income Statement and Tax Payable on Balance Sheet
• The Tax Payable (Balance Sheet account) shows the provision made by the company for taxes, and is estimated based on the year’s profit. The actual cash tax charge is finalized by the tax authorities later.
• The tax charge on the Income Statement captures the aggregate change in the Tax Payable and Deferred Tax (both Balance Sheet accounts) from one period to the next.
• Accounting entries
• Dr Taxes (Income Statement)
• Cr Tax Payable (Balance Sheet)
• Recognition in OCI
• If the gain or loss being taxed was recognised in OCI, the taxes should also be recognised in OCI.

Deferred Tax

• Deferred Tax adjusts for temporary differences (e.g. timing differences of accounting depreciation vs. tax capital allowance), but not for permanent differences (e.g. business entertainment is deductible for accounting purposes but not for tax purposes)
• Calculation of Deferred Tax (Full Provision Method)
• Temporary difference = Carrying value – Tax base
• Carrying value of assets and income are positive, for liabilities and expenses are negative.
• There is no temporary difference that arises for the “deferred tax” account.
• For Non-Current Assets
• Tax base (a.k.a tax written down value) = Cost – Cumulative Capital Allowances
• Carrying value = Cost – Depreciation
• Temporary difference > 0
• Taxable temporary difference
• Deferred Tax Liability (DTL) = Tax rate * Temporary difference
• Temporary difference < 0
• Deductible temporary difference
• Deferred Tax Asset (DTA) = Tax rate * Temporary difference
• The Tax Rate used is the tax rate expected to apply in the period when the temporary difference is realised (stipulated by current regulations, not subjective expectations). This is known as the Liability Method.
• The way to figure out whether something is a taxable or deductible temporary difference is to think whether the entity will need to pay more or less cash taxes in the future due to the timing difference. Most of the time, if you pay less tax now,  you end up needing to pay more tax later on. More cash taxes later mean a liability (i.e. taxable), less mean an asset (i.e. deductible).
• Accounting entries
• Dr Taxes (Income Statement)
• Cr Deferred Tax Liability (Balance Sheet)
• Recognition in OCI
• If the gain or loss being taxed was recognised in OCI, the taxes should also be recognised in OCI.
• Deferred tax asset / liability is not allowed to be discounted to present value because it is too difficult to forecast to be reliable.

Tax Base

• If an item is not taxed, or not tax deductible, its tax base is equal to its carrying value, so that no temporary differences will arise.
• E.g. impairment of goodwill is not tax deductible, and does not create a temporary difference.

Taxable Temporary Differences (Deferred Tax Liability)

Scope

• A deferred tax liability should be recognised for all taxable temporary differences except for
• Initial recognition of goodwill
• Initial recognition of a transaction that neither affects accounting nor tax profits.

Common Scenarios that Result in Deferred Tax Liability

• Accrual Income/Expense vs. Actual Cash Flow
• Interest receivable are accrued and posted to P&L as income, but only taxed when received.
• Development cost may be capitalised and amortised, reducing future accounting profits, but tax relief was given when the costs were first incurred.
• Revaluations
• Tax base is typically unchanged even though an asset is revalued. The gain in value is taxed when the asset is disposed.
• Since revaluation is recognised in OCI, any tax effects are also recognised in OCI (e.g. increase in deferred tax liability due to increase in carrying value). This impact will flow from OCI to the revaluation reserve, lower the reserve (in the case of upwards revaluation).
• Initial accounting entries
• Dr Non-Current Asset with (Revalued amount – original cost)
• Dr Accumulated Depreciation with (accumulated deprecation for the revalued asset)
• Cr OCI (Revaluation Surplus) with (Revalued amount – carrying value)
• Cr Deferred Tax Liability with (increase in deferred tax liability)
• Dr OCI (Revaluation Surplus) with (increase in deferred tax liability)
• Subsequent accounting entries (for transfer from revaluation reserve to retained earnings)
• Cr Retained Earnings with (excess depreciation due to revaluation)
• Dr Revaluation Surplus with (excess depreciation due to revaluation)
• Dr Deferred Tax Liability with (decrease in deferred tax liability)
• Cr OCI (Revaluation Surplus) with (decrease in deferred tax liability)
• Hence eventually Revaluation Surplus decreases by (excess depreciation due to revaluation - decrease in deferred tax liability)
• Note that any increase in deferred tax liability due to the difference between depreciation and capital allowance is still captured in P&L.
• At disposal, remaining balances on both revaluation surplus and deferred tax are transferred to retained earnings.

Deductible Temporary Differences (Deferred Tax Asset)

Scope

• Recognised only to the extent that it is probable that
• The temporary difference will reverse in the foreseeable future; and
• Taxable profit will be available against which the temporary difference can be utilised.
• Deferred tax asset is also recognised for unused tax losses and unused tax credits that are being carried forward.

Common Scenarios that Result in Deferred Tax Asset

• Retirement benefit costs
• Expensed in P&L based on accrual concept but are only tax deductible when cash benefits are paid out.
• Share-based payments
• FV of share options are expensed to P&L over vesting period, but the tax deduction only occurs when the options are exercised.
• Computation
• The Tax Base is based on the usual computation for Carrying Value of the Share-based Payment Reserve, but the FV at grant date is substituted with the Intrinsic Value of the options at each reporting date.
• The Carrying Value is 0 for deferred tax computation purposes, as the Tax Base will be fully tax deductible.
• Hence Deferred Tax Asset = Tax Rate * [Expected number of instruments that will vest * Intrinsic value at Reporting Date * (Reporting Date – Grant Date) / (Vesting Date – Grant Date)]
• Note that at the Exercise Date, the tax receivable will indeed be the tax rate * intrinsic value of all vested options. The FV at grant date does not come into the picture.
• Recognition
• If the estimated/actual tax deduction (i.e. the tax base) <= cumulative recognised P&L expense, the change in deferred tax asset is recognised in P&L.
• If the estimated/actual tax deduction (i.e. the tax base) > cumulative recognised P&L expense, the excess tax benefits are recognised in OCI, flowing through to a separate equity reserve.

Deferred Tax in Business Combinations

Initial Goodwill

• No recognition of DTL on goodwill or the subsequent impairment of this goodwill.

Adjustment of Goodwill and Recognition of DTL/DTA

1. Revaluation of assets/liabilities
• Carrying value of assets and liabilities are adjusted to FV after a business combination but the tax base remains unchanged.
• Calculate the total temporary differences at consolidation and adjust the deferred tax account (there may already be some existing).
• Any recognition of a DTL will reduce the fair value of net assets acquired, which in turn increases the goodwill by the same amount. This DTL is not expensed in P&L.
2. Recognition of Parent’s DTA
• Parent company may have an unrecognised DTA because it has no taxable profits to use against.
• If the DTA can be used against the Sub’s taxable profits, the Parent will recognise the DTA, which in turn decreases the goodwill.
• Goodwill = Cost of investment – (Shares of net assets acquired + DTA recognised).

Undistributed Profits of Group Companies

• How DTL Arises
• Tax base is the original cost of investment
• Carrying value increases by the group’s share of profits over time
• The temporary difference is reversed when the investment pays out its profits as dividends, which would reduce the carrying value of the investment.
• An entity should recognise a DTL for the above unless both conditions are satisfied
• Entity is able to control the timing of the reversal of the temporary difference; and
• It is probable that the temporary difference will not reverse in the foreseeable future.
• Hence a DTL can be not recognised for Subs and JV’s (>50% ownership), but not for Associates.

Unrealised Profits in Intra-Group Trading

• How DTA Arises
• For intra-group trading with inventory still held in the group, the unrealised profit is eliminated for accounting purposes, but still remains for tax purposes.
• Hence more cash tax is paid now relative to accounting tax (but less cash tax is to be paid later relatively). This creates a DTA.
• DTA = Eliminated URP * buyer’s tax rate
• Note that the Current Tax provision (Balance Sheet Liability) of the seller in its separate financial statements would have included the tax provision for the URP. This needs to be eliminated during consolidation, while recognising a DTA calculated as above.

Presentation

Offsetting DTL and DTA

• DTL and DTA of the same tax jurisdiction can be offsetted.
• If the net result is a DTA however, it can only be recognised if it is probable that it will be recovered in the foreseable future.

Current Tax and Deferred Tax

• DTL and DTA are classified under non-current in the Balance Sheet.
• Current tax asset and current tax liability can only be offsetted if there is a legal right to do so with the same tax authority.

Should Deferred Tax Liability Count Towards Invested Capital in Investments Analysis? [my thoughts]

• The question here is whether or not the deferred tax liability is a real liability that needs to be paid, or a liability that can be held indefinitely without being paid.
• If a company that keeps on investing in fixed assets for example, and generates new deferred tax liability faster than the previous temporary differences are reversed, then the company will end up with a (growing) deferred tax liability balance that will never need to be paid. In such a situation, deferred tax liability should be subtracted from Invested Capital (similar to non-interest-bearing current liabilities) so that the investor is actually investing less capital.
• Whereas if the company in question has a history of realising deferred tax liabilities, then they should not be subtracted from Invested Capital, so those liabilities form part of the capital that an investor needs to place in the company.

-END-

• IAS 32 - Financial Instruments: Presentation
• IAS 39 – Financial Instruments: Recognition and Measurement
• IFRS 9 – Financial Instruments
• IFRS 7 – Financial Instruments: Disclosures

IAS 32 – Financial Instruments: Presentation

Liability vs. Equity

Definitions

• A Financial Liability is any liability where the issuer has a contractual obligation:
• to deliver cash or another financial asset to another entity, or
• to exchange financial instruments with another entity on potentially unfavourable terms
• An Equity Instrument is any contract that offers the residual interest in the assets of the company after deducting all of the liabilities.
• An instrument is an Equity Instrument if
1. There is no obligation to transfer cash or another financial asset to another party; and
2. It will not be settled with a variable number of its equity instruments.

Preference Shares

• Redeemable Preference Shares
• Repurchased by the issuer at a fixed amount on a fixed date.
• Classified as a Financial Liability.
• Dividends paid to such shares are accounted as Finance Cost in Income Statement
• Irredeemable Preference Shares
• If it has a fixed cash dividend, that is a liability component.
• If it is entitled to participate in dividends paid on ordinary shares, that is an equity component
• Classified as a Compound Financial Instrument (see below)
• ‘Normal’ Preference Shares
• Typical preference shares come with a fixed dividend, preference in event of liquidation, but does not have rights to the residual interests in the company.
• Hence they are classified as a Financial Liability.

Accounting for Cash Flows of a Financial Liability

• All interest, dividend, losses, gains, are recognised as income or expense in P&L.

Accounting for Cash Flows of an Equity Instrument

• Distributions to holders and transaction costs are debited directly to equity, net of any related income tax benefit.

Compound Financial Instruments

• Instruments that contain both a liability and equity component needs to be split into these two components and recognised separately in the Balance Sheet.
• Transaction costs incurred in issuance are allocated proportionately to the liability and equity values.

Convertible Debt

• Valuation
• Value of liability component = Debt component valued independently as if there was no conversion feature, using the market yield for straight debt.
• Value of convertible bond = Original proceeds at inception, or FV subsequently
• Value of equity component (i.e. the conversion feature) = Value of convertible bond – Value of liability component
• Accounting at issuance
• Dr Cash Proceeds
• Cr Bond Liability with value of liability component
• Cr Equity (convertible bond option proceeds) with value of equity component
• For entity’s own issued debt, IAS 39 requires it to be classified as ‘Financial liability measured at amortised cost’. As the liability component was valued using the market yield at inception, the interest rate used for unwinding the discount is also the same market yield.
• Accounting at conversion
• Dr Bond Liability [eliminate the value at conversion]
• Dr Equity (convertible bond option proceeds) [this didn't change from issuance]
• Cr Share Capital
• Cr Share Premium

Treasury Shares

• Shares bought back are either
• Deducted from share equity; or
• Offset against share equity and disclosed
• Gains/losses are recognised in Other Comprehensive Income and not reported in P&L.

Offsetting Financial Assets and Liabilities

A financial asset and a financial liability can be offset and shown net in the Balance Sheet if the company

1. Has a legal right to set off the amounts; and
2. Intends to settle on a net basis, or settle the liability immediately when the asset is sold off.

IAS 39 – Financial Instruments: Recognition and Measurement

Note that IFRS 9 will be replacing IAS 39.

Financial Liabilities

Recognition Principle

• Recognised once entity becomes a party to the contractual provisions of the instrument. Hence Forward contracts are recognised at inception even though the value would be zero.

Classes of Financial Liabilities

1. Financial liabilities at fair value through P&L (FVPL)
• Held for trading
2. Financial liabilities measured at amortised cost (FLAC)
• Held to maturity

Initial Measurement

• Fair value, typically proceeds received.

Accounting for Transaction Costs (e.g. issuance cost) [This applied to both Financial Assets and Financial Liabilities]

• If instrument is classified as FV through P&L (FVPL), then it is expensed in P&L.
• Else, it is capitalised and lowers the FV of a liability or increases the FV of an asset.

Subsequent Measurement

• FVPL
• Re-measured to FV at each reporting date.
• Gains/losses recognised in P&L.
• Interest and dividends recognised in P&L.
• FLAC
• Measured at amortised cost (i.e. the same method as for provisions and operating lease accounting)
• Opening balance
• + Interest expense (original effective interest * opening balance)
• - Actual interest paid
• = Closing balance
• Interest recognised as Finance Cost in P&L, using effective interest rate.
• Note that eventually the total Finance Cost charged to P&L will be = Redemption value (can be a premium to the principal) + cash interest to be paid – initial recognition value.

Financial Assets (IAS 39 – to be superseded by IFRS 9 by 1 January 2013)

Classes of Financial Assets

1. Financial assets at fair value through P&L (FVPL)
• Held for trading
• Derivatives
2. Held-to-maturity investments
3. Loans and receivables
• Not quoted in an active market
4. Available-for-sale financial assets
• “Catch all” category

Initial Measurement

• At cost, which is the same as FV at inception
• Trade receivables are not discounted to present value because they are short-term.

Subsequent Measurement

1. Financial assets at FVPL
• FV at each reporting date
• Gain/loss reported in P&L.
2. Held-to-maturity investments
• Carried at amortised cost
3. Loans and receivables
• Carried at amortised cost
4. Available-for-sale financial assets
• FV at each reporting date
• Gain/loss reported in Other Comprehensive Income, and taken to an equity reserve (e.g. available-for-sale reserve)

Disposal

1. FVPL
• Gain/loss taken to P&L.
2. Available-for-sale financial assets
• Cumulative gains/losses are removed from the equity reserve, and transferred to P&L.
• Accounting entries
• Dr Cash with sales proceeds
• Cr Investment with carrying amount
• Dr Available-for-sale reserve with cumulative gains/(losses)
• Cr P&L with (carrying amount – sales proceeds + cumulative gains/(losses))
• To prevent double counting since previous gains/losses were previously recognised in OCI, a matching loss/gain is entered into OCI (reclassification adjustment).

Impairment

1. Instruments at FVPL
• Impairment loss recognised in P&L.
2. Instruments carried at amortised cost
• Impairment loss recognised in P&L
• Carrying value on Balance Sheet either written down or offset by an allowance account.
3. Instruments classified Available-for-Sale
• Impairment loss recognised in P&L
• Previously recorded loss in equity reserve (through OCI) also transferred to P&L.

Derecognition of Financial Assets and Liabilities

Derecognition criteria

• Financial Asset – Contractual rights to cash flows expired or substantially all of the risks/rewards of ownership have been transferred. The financial asset is also derecognised if some risks and rewards are retained but control is lost.
• Financial Liability – Obligations expired or discharged.

Accounting for Factoring

• Without recourse (asset derecognised)
• Transfer asset
• Dr Cash
• Cr Receivables
• Account for fees
• Dr Expense (P&L)
• Cr Receivables
• With recourse (asset retained)
• Retain risk while receiving cash
• Dr Cash
• Cr Liability
• Reduce risk while receivables are paid by customers
• Dr Liability
• Cr Receivables
• Account for fees
• Dr Expense (P&L)
• Cr Receivables

IFRS 9 – Financial Instruments

Note that IFRS 9 will be replacing IAS 39. The following section is only on Financial Assets in IFRS 9, and does not cover Financial Liabilities in IFRS 9.

Financial Assets

Initial Measurement

• Fair value

Subsequent Measurement

• If Financial Asset is a debt instrument
• The Financial Asset is measured at amortised cost if both of these two tests are passed, else it is measured at FV through P&L (FVPL):
• Business model test
• Contractual cash flow characteristics test
• Business model test
• Is the business model of the entity to trade assets or to collect contractual cash flows (i.e. hold to maturity)?
• If hold to maturity, Pass, else Fail.
• Contractual cash flow characteristics test
• Does the contractual cash flows come on specified dates, and consist solely of principal and interest based on an outstanding principal?
• If yes, Pass, else Fail (e.g. complex derivatives)
• If Financial Asset is an equity instrument
• If it is held for trading, measured at FVPL
• Else entity can irrevocably elect to measure at FV through Other Comprehensive Income (FVOCI).
• Dividends are still recognised in P&L, unless they are a recovery of part of the investment.
• Fair value changes recognised in OCI, and flow through to an equity reserve (not retained earnings).
• Regardless of the above, an entity can choose to irrevocably designate a Financial Asset at FVPL if it eliminates or significantly reduces a measurement mismatch (e.g. a closely related financial liability is measured at FVPL but the financial asset is otherwise made to be carried at amortised cost).

Disposal

• Financial Asset measured at FVPL
• Account for the proceeds
• Dr Cash (Balance Sheet)
• Cr Gain/Loss on Disposal (Income Statement)
• Account for the carrying value
• Cr Investment (Balance Sheet)
• Dr Gain/Loss on Disposal (Income Statement)
• Financial Asset measured at FVOCI
• On disposal, the equity reserve can be transferred to retained earnings without recycling through P&L.
• [It is not clear whether the gain/loss on disposal goes to P&L or still to OCI.]

Accounting for Interest-Free Loans to Employees

• The Financial asset is recognised and fair valued using the market interest rate.
• The difference between the cash given out and the fair value of the financial asset is recorded as Employee Cost
• Accounting entries
• Cr Cash
• Dr Financial Asset
• Dr Employee Compensation [I'm not sure whether this is in P&L or is a Balance Sheet account that is amortised. In my view, it is more appropriately accounted for as a deferred asset if the loan terminates when the employee leaves because then the compensation captures future benefits that the company will receive from the employee. If the loan is independent of the employee's employment with the firm, then I would be inclined to immediately expense it through P&L because then the compensation is for employee's past services.]

Impairment of Financial Assets

• Entities must assess, at the end of each reporting period, for
• Objective evidence of impairment due to a ‘loss event’
• The impact of the loss event on estimated future cash flows of their financial assets
• Only losses (expected or realised) due to past events can be used for impairment, not expected losses from expected events.
• Impairment is automatically handled for financial assets measured at fair value (either through P&L or OCI).
• For financial assets carried at amortised cost
• Impairment loss = PV (using original effective interest rate) of estimated future cash flows – carrying amount
• Recognised in P&L and carrying amount either written down or set off against an allowance account.

Derivatives

Definition

A derivative must have all three characteristics below

1. Its value changes in response to the change in another variable (which in the case of a non-financial variable, is not specific to a party to the contract);
2. Its initial net investment is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
3. It is settled at a future date.

Measurement

• Fair value through P&L (FVPL)

Embedded Derivatives

Definition

• An embedded derivative is a component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.

An embedded derivative is separated from the host contract and accounted for as a derivative (and the host contract accounted for under its appropriate standard) if

1. the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host;
2. a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
3. the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss.

A foreign currency denominated contract contains an embedded derivative unless it meets one of the following criteria:

1. The currency is the functional currency of either party to the contract;
2. The currency is routinely used in commercial transactions of the particular good or service (e.g. US$ for oil prices); or
3. The currency is commonly used in such contracts in the market in which the transaction takes place (e.g. US$ in South America).

Despite the above, an entity may designate the entire hybrid contract as at FVPL unless:

1. it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative is prohibited (e.g. prepayment option in a mortgage)
2. the embedded derivative does not significantly modify the cash flows that otherwise would be required by the contract.

In IFRS 9, there is an additional key requirement that if a hybrid contract contains a host that is a Financial Asset under IFRS 9, then the entire hybrid contract is treated like a Financial Asset.

Hedge Accounting (IAS 39)

Types of Hedging Relationships

1. Fair value hedge
• Hedge against changes in fair value of an asset/liability or firm commitment, that could affect P&L
2. Cash flow hedge
• Hedge against variability in cash flows of an asset/liability or a highly probable forecast transaction, that could affect P&L.
3. Hedge of a net investment in a foreign operation

Conditions to be met for hedge accounting to be used

• Formal documentation at inception of hedge detailing the hedging instrument, hedged item, hedged risk, type of hedge, method of testing effectiveness, etc;
• Hedge must be highly effective (change in hedging instrument / change in hedged item = 80% to 125%);
• Hedge must be assessed regularly and found to be highly effective;
• Hedge effectiveness can be reliably measured.

Fair Value Hedges

Accounting

• Gain/loss on the hedging instrument (measured at FV) recognised in P&L.
• Gain/loss on the hedged item also recognised in P&L.

Cash Flow Hedges

Accounting

• Gain/loss on hedging instrument is split into ‘effective’ and ‘ineffective’ portions.
• Effective portion is recognised in OCI, ineffective portion is recognised in P&L.
• When the hedged item’s forecast cash flows affect P&L, the cumulative amount recognised in OCI is released to the P&L.
• Dr Equity Reserve (through debiting OCI, as a reclassification adjustment)
• Cr Income Statement

Hedge of a Net Investment in a Foreign Operation

Conditions

• A hedging instrument can be designated as a hedge against the changes in the value of the net assets of a foreign operation, provided that the value of the hedging instrument is <= the value of the net assets.
• The hedging instrument can be held within any entity in the group.

Accounting

• Per IAS 21, foreign exchange differences during consolidation of the net investment in a foreign operation is recognised in OCI.
• Gains/losses on the hedging instrument will also be recognised in OCI.

Disposal of Foreign Operation

• Cumulative gain/loss on the hedging instrument will also be reclassified from equity reserve to P&L, along with the reclassification of foreign translation reserve to P&L.

IFRS 7 – Financial Instruments: Disclosures

Companies must disclose information that enables users to evaluate the

• Significance of financial instruments for the entity’s financial position and performance; and
• Nature and extent of risks, and how the entity manages those risks.

Significance of Financial Instruments

Statement of Financial Position Disclosures

• Carrying amounts of financial assets and liabilities
• Reclassifications and derecognition
• Financial assets pledged as collateral
• Reconciliation of assets with their allowance accounts.
• Defaults and breaches for loans payable.

Statement of Comprehensive Income Disclosures

• Net gains and losses on financial instruments
• Interest income and expense
• Fee income and expense
• Impairment losses

Other Disclosures

• Hedge accounting details
• Fair value of financial assets and liabilities

Nature and Extent of Risks

Qualitative and quantitative disclosure of risks arising from financial instruments

• Credit risk
• Maximum exposure
• Credit quality, enhancements
• Carrying amount of impaired or ‘past due’ assets
• Liquidity risk
• Maturity analysis of financial liabilities
• Market risk
• Sensitivity analysis of each type of market risk to P&L and equity.
• Other price risk

-END-

• IFRS 2: Share-Based Payment

Three types of share-based payment

1. Equity settled: Settled in entity’s shares or share options.
2. Cash settled: Settled in cash based on entity’s share price (e.g. share appreciation rights)
3. Settled either by equity or cash: Choice by either the entity or the awardee.

Equity Settled Transactions

Initial Recognition

• Cost recognised is the FV of the goods and services received (i.e. by the company from the employee’s that are getting the share-based payment)
• If the goods and services cannot be measured reliably (which is most of the time duh!), the cost recognised is the FV of the equity instruments granted at Grant Date.
• Accounting entries for issuance of shares
• Dr Purchases (for payment to suppliers) or Dr Wages (to employees)
• Cr Share Capital
• Cr Share Premium
• Accounting entries for stock options
• Dr Employment Cost Expense (Income Statement)
• Cr Share-based payment reserve (Balance Sheet under Equity)
• The initial recognition is only for those that have vested, those with a vesting period will not be recognised at the grant date itself but will be recognised subsequently (see Subsequent Recognition for more details).
• Note that market-based conditions are factored into the FV of the instruments at Grant Date, while non-market-based conditions are factored into the expected number of instruments that will vest.

Subsequent Recognition

• At each reporting date before the vesting date, estimate the expected number of instruments that will vest. At the vesting date, the number of instruments is the actual number of instruments that vested.
• The FV of each instrument used is measured at grant date, and is not remeasured.
• Cumulative Cost = Expected number of instruments that will vest * FV of each instrument measured at grant date * (Reporting Date – Grant Date) / (Vesting Date – Grant Date)
• Accounting entries
• Dr Employment Cost Expense (Income Statement)
• Cr Share-based payment reserve (Balance Sheet)
• Amount for both entries is (Cumulative cost of options at end of current year – Cumulative cost of options at end of previous year).
• On early settlement of an award without replacement, a company should charge the balance that would have been charged over the remaining period, i.e. the charges are accelerated.
• In the event where the vesting period is longer than expected (e.g. can happen if the vesting period is due to a market condition), the expense is recognised over the original expected vesting period.

Cash Settled Transactions

Initial Recognition

• Liability recognised in Balance Sheet, measured at FV.

Subsequent Recognition

• Liability remeasured each year at FV until settlement, change in liability is expensed to P&L.
• If there is a vesting period, the treatment is the same as per equity settled transactions, the only difference is that the FV of the instrument used is the updated FV as of each reporting date.

Transactions Settled either by Equity or Cash

If the choice of settlement method lies with the employee

• Account for it as a Compound Financial instrument

If the choice of settlement method lies with the company

• If the company tends to settle in cash, then treated as a cash settled transaction, else treated as an equity settled transaction

Deferred Tax Implications

• Some jurisdictions gives a tax allowance for share-based transactions. A Deferred Tax Asset is recognised only if there are sufficient future taxable profits available.
• Value of the deferred tax asset = Total intrinsic value of all options (i.e. market price – exercise price) * Tax rate * (Reporting Date – Grant Date) / (Vesting Date – Grant Date)

Situations involving Parent and Subsidiary

• If a Parent grants rights (to the Parent) to the employees of its Subsidiary, the Sub will account for it as an equity settled transaction, with the increase in Equity recognised as a contribution from the Parent.
• If a Sub grants rights (to the Parent) to the Sub’s employees, the Sub will account for it as a cash settled transaction.
• Guidance for other situations is provided in IFRIC 11.

-END-

• IAS 16: Property, Plant and Equipment
• IAS 23: Borrowing Costs
• IAS 20: Accounting for Government Grants and Disclosure of Government Assistance
• IFRS 5: Non-Current Assets Held for Sale and Discontinued Operations
• IAS 40: Investment Property
• IAS 38: Intangible Assets
• IAS 36: Impairment of Assets

IAS 16: Property, Plant and Equipment

Initial Measurement

Recorded at cost

• Included costs
• Purchase cost (after trade discounts but before settlement discounts (e.g. for early cash payments), including transport and handling costs and non-refundable tax e.g. import duties) or direct costs if self-constructed (i.e. no indirect overheads)
• Relevant borrowing costs
• Costs directly related to getting the asset ready for use
• site preparation
• installation
• testing the asset
• professional fees (legal costs, surveyors, architects, etc.)
• Dismantling and restoration costs
• Excluded costs
• Maintenance contract costs. These are revenue expenses and not capital expenses.
• Early settlement discounts are treated as Income.
• Abnormal costs arising from errors

Subsequent Expenditure

• Subsequent expenditure on a non-current asset that enhances economic benefits from the asset, should be capitalized.
• If a component is replaced, the net book value of that component should be removed from Balance Sheet and the cost of the replacement capitalized and added.

Subsequent Measurements

Two choices:

1. Cost model, i.e. cost minus accumulated depreciation (based on cost) minus accumulated impairment losses
2. Revaluation model, i.e. revalue to fair value using open market value, depreciated replacement cost, etc.
• Note that if the revaluation model is chosen for an asset, it must be applied to assets of the same class (e.g. land, buildings, PP&E are different classes)

Revaluation

Upwards revaluation

• Accounting entries
• Dr Non-Current Asset with (Revalued amount – original cost) [essentially Cr Non-Current Asset with original cost, and Dr Non-Current Asset with revalued amount]
• Dr Accumulated Depreciation with (all accumulated depreciation associated with revalued asset) [essentially eliminating all accumulated depreciation.]
• Cr Other Comprehensive Income (Revaluation Surplus) with (Revalued amount – carrying value)
• Subsequent downwards revaluation
• Dr Other Comprehensive Income (offsets the previous gain recorded in the revaluation surplus associated with this asset)
• Dr Income Statement (if the drop in value exceeds the ‘buffer’ that existed in the revaluation surplus, the excess beyond that)
• Cr Non-Current Asset
• Note that IAS 16 gives a choice of whether to eliminate accumulated depreciation during a revaluation, or to restate it proportionately so that the carrying amount after revaluation equals its revalued amount.

Downwards revaluation

• Accounting entries
• Cr Non-Current Asset with (Revalued amount – carrying value)
• Dr Income Statement
• Subsequent upwards revaluation
• Cr Income Statement (to the extent of the previous revaluation loss in the P&L associated with this asset)
• Cr Other Comprehensive Income (if the rise in value exceeds the ‘buffer’ that existed in the P&L, the excess beyond that)
• Dr Non-Current Asset

Depreciation of Revalued Asset

• Depreciation is charged on the revalued amount as per normal
• Two choices of ways to handle the Revaluation Surplus account
• (1) Transfer directly (not through P&L) to Retained Earnings when the asset is derecognised (e.g. disposal).
• (2) Transfer directly any “excess depreciation” from Revaluation Surplus to Retained Earnings
• Essentially the decrease in value due to depreciation is “split” between Retained Earnings and the Revaluation Reserve, so that eventually when the asset is fully depreciated, the Revaluation Reserve would drop to zero. Essentially the depreciation amount based on the old asset value prior to revaluation, remains within the Retained Earnings (came in from P&L), while the additional excess depreciation due to the revaluation (which also came into Retained Earnings from P&L) is netted off with the Revaluation Reserve.
• Accounting entry to transfer excess depreciation charge
• Dr Revaluation Reserve, Cr Retained Earnings with (new depreciation based on revalued amount – old depreciation based on old asset value)

Disposal

Gain/(loss) on Disposal

• Calculated as (Proceeds – carrying value) at date of disposal
• Recognised in Income Statement (but not in Revenue)
• Any remaining revaluation reserve is transferred to retained earnings, and does not go through the P&L.

IAS 23: Borrowing Costs

Eligible Costs

• When an entity borrows money to acquire or construct a qualifying asset, the cost of the asset must include the actual borrowing costs incurred, less income from the temporary investment of the money borrowed.
• When general company borrowings are used, the weighted average cost of interest across the general borrowings is applied.
• The capitalization of borrowing costs (and the subtraction of income from temporary investment) is suspended during the time construction is suspended.

IAS 20: Accounting for Government Grants and Disclosure of Government Assistance

Two types of Grants

• Capital Grants for buying assets
• Revenue Grants for other purposes

Revenue Grants

Initial recognition

• Dr Cash, Cr Deferred Income (liability) with the cash grant amount

Subsequent Matching of Grant with Related Expense

• In the periods when the related expenses (i.e. expenses incurred to meet the terms of the grant) are incurred, release the grant amount into the P&L either by
• showing the grant income as a separate line item by itself
• showing the related expense item, net of the grant income
• Cr Income Statement, Dr Deferred Income (liability)

Capital Grants

Two accounting treatments allowed

1. Reduce the cost of the Non-Current Asset by the Grant amount (i.e. Dr Cash, Cr Non-Current Asset). Depreciate the net cost as per normal.
2. Do the same as for Revenue Grants, i.e. record initially in Deferred Income, then release the Deferred Income into P&L over the useful life of the asset (just like depreciation).

Grants that Reimburse Costs Incurred Previously

• Immediately recognise the grants in the period when they are received.

IFRS 5: Non-Current Assets Held for Sale and Discontinued Operations

Requirements to be met to be classified held-for-sale

• Asset available for immediate sale at its present condition
• Sale is highly probable
• Active programme in place to find buyers
• Actively marketed at a reasonable price
• Management is committed to the disposal plan
• Sale is expected to be completed within 1 year of classification as held-for-sale

Measurement of Non-Current Asset Held for Sale

• Lower of
• Carrying value (i.e. net book value) and
• Fair value less costs to sell (FVLCTS)
• No further depreciation is charged to the asset before the disposal.

IAS 40: Investment Property

Definition

• Land or building held by the owner or by the lessee under a finance lease to
• Earn rentals and/or
• Capital appreciation
• Excludes
• Property intended for sale in the ordinary course of business (IAS 2: Inventory, e.g. home builders)
• Property constructed for 3rd parties (IAS 11: Construction Contracts)
• Property occupied by owner (IAS 16: Property, Plant and Equipment)
• Property being constructed for the purposes of being an investment property after completion (IAS 16 during construction)
• Property awaiting disposal (IFRS 5)
• Property leased to another entity under a finance lease (IAS 17: Leases)
• For properties held under operating leases (i.e. the company is the lessee), the company can choose whether to recognise it as an investment property.
• Land held for indeterminate future use is an investment property where the entity has not decided that it will use the land as owner occupied or for short-term sale.

Initial Measurement

• At cost, same as per IAS 16: Property, Plant and Equipment.

Subsequent Measurement

Two choices (choice to be applied to all properties):

1. Cost model, i.e. cost minus accumulated depreciation (based on cost)
• Fair value must be disclosed in notes to financial statements.
2. Fair value model, i.e. revalue to fair value using open market value, depreciated replacement cost, etc.
• All gains/losses are recognised in P&L, no revaluation surplus.
• No depreciation is charged.

For property held under a Finance Lease (i.e. company is the lessee)

• Per IAS 17: Leases, measured at the lower of
• Fair value; and
• Discounted present value of the expected future lease payments

For property held under Operating Lease (i.e. company is the lessee)

• The company can choose whether to recognise it as an investment property.
• If yes, same treatment as though it is a Finance Lease.
• If no, per IAS 17: Leases, the property will be excluded from the Balance Sheet.

IAS 38: Intangible Assets

Definition

• Conditions to be satisfied
• Identifiable
• Can be separated and sold; or
• Cannot be separated but arises from a contractual or legal right.
• Non-monetary
• Asset
• Expected future benefit that can be reliably measured
• Excludes
• Deferred tax assets (IAS 12: Income Taxes)
• Leases (IAS 17: Leases)
• Assets arising from employee benefits (IAS 19: Employee Benefits)
• Financial assets (IAS 39: Financial Instruments)
• Goodwill acquired in a business combination (IFRS 3: Business Combinations)
• Non-current intangible assets classified as held for sale (IFRS 5: Non-current Assets Held for Sale and Discontinued Operations)
• Mineral rights and expenditure on the exploration, development, extraction of minerals, oil and natural gas (IFRS 6: Exploration for and Evaluation of Mineral Assets).
• Internally-generated intangible assets (e.g. brands, customer lists, etc.) are not recognised because they are not separable, and difficult to reliably measure (special rules apply for R&D).

Initial Measurement

• At cost.
• If acquired as part of a business combination, at fair value.

Subsequent Measurement

Two choices (same choice applied to the same class of intangibles):

1. Cost Model
• For intangible assets with finite useful life, amortize. Test for impairment if there is evidence indicating possible impairment.
• For intangible assets with indefinite useful life, test for impairment annually.
2. Revaluation Model
• Only allowed if there is an active market to establish fair value

Internally Generated Intangible Assets

Accounting for Research Costs

• Must be expensed in P&L as incurred.

Accounting for Development Costs

• Can be capitalized provided it meets ALL of the following criteria (BEAUTI mnemonic)
1. Benefits: Future economic benefits can be generated. E.g. how it can be used to generate benefits, or the existence of a market to sell
2. Expenditure on the intangible asset can be reliably measured.
3. Availability of resources to complete the development.
4. Used or sold: Intangible asset can be sold or used
5. Technically feasible to complete the development.
6. Intention to complete the development then use or sell it.

Accounting for Website Development Costs

• A website that promotes and advertises the company’s products does not meet the requirement that it will generate future economic benefits, so such costs are expensed.
• A website that allows customers to place orders will generate future benefits, so such costs can be capitalized.

Accounting for Computer Software Development Costs

• Software essential to the operation of the hardware is capitalized as part of the hardware cost as per IAS 16.
• Standalone software packages will fall under IAS 38, to be put through the BEAUTI test.

Initial Recognition for Allowable Internally-Generated Intangible Assets

• All directly attributable costs including
• cost of materials and services
• cost of employee benefits
• fees to register a legal right
• amortisation of patents and licences used
• depreciation of equipment used
• Does not include costs for
• SG&A overheads
• inefficiencies and initial operating losses
• staff training to use asset

Goodwill (under IFRS 3: Business Combinations)

• Not amortized,  but tested annually for impairment as per IAS 36: Impairment of Assets.
• For negative goodwill, or ‘bargain purchase’
• Recognise a Gain in the P&L immediately, attributable to the Owners of the Parent.
• The amount of the gain recognised = Parent’s interest in the FV of the net assets – Parent’s cost of investment in the Sub

IAS 36: Impairment of Assets

Definitions

• Recoverable Amount = Higher of
• Fair value less costs to sell (FVLCTS)
• Price in a binding sale agreement with a knowledgeable, willing party at arm’s length, less disposal costs.
• If there is no binding agreement, use the asset’s market price in an active market less the costs of disposal.
• If there is no active market, use the outcome of recent transactions for similar assets within the same industry.
• Costs to sell include legal costs, stamp duty, cost of removing asset, and direct incremental cost to being an asset into condition for its sale.
• Value in use (VIU)
• PV of future cash flows from using the asset, including cash flows at disposal.
• The discount rate can include the price of risk and illiquidity.
• For investment in Associates, the value in use will be the Parent’s share of the PV of future cash flows (either from operations or from dividends) and proceeds from the disposal of the investment.
• Impairment loss = asset’s carrying value – its recoverable amount.

Scope

• Applies to all assets except
• Inventories (IAS 2)
• Assets arising from construction contracts (IAS 11)
• Deferred tax assets (IAS 12)
• Assets arising on a pension scheme (IAS 19)
• Financial instruments (IAS 39)
• Investment property measured at fair value (IAS 40)
• Biological assets measured at fair value (IAS 41)
• Non-current assets held for sale (IFRS 5)

Impairment Testing Requirement

• Annually for
• Goodwill
• Intangibles with indefinite useful lives
• Intangibles that have not yet been used (e.g. capitalized development costs where amortization is not yet started)
• For all assets, when there is an indication of impairment at the reporting date

Accounting Entries for Impairment Losses

• For assets held at cost
• Dr Income Statement (before operating profit)
• Cr Non-Current Asset
• For assets using revaluation model
• Dr Other Comprehensive Income (offsets the previous gain recorded in the Revaluation Surplus associated with this asset)
• Dr Income Statement (with any excess impairment beyond the Revaluation Surplus)
• Cr Non-Current Asset

Reversal of Impairments

• Scope
• No reversal of impairment on goodwill.
• Reversal of impairment on other assets/CGUs allowed.
• Note that an asset’s VIU will simply increase with the passage of time due to the cash inflows becoming closer. This does not increase the service potential of the asset, so this reason by itself is not sufficient to justify a reversal of impairment.
• Amount
• Impairment reversal cannot result in the carrying value of the asset exceeding its carrying value had there been no impairment in the first place.
• Accounting Treatment
• For assets held at cost
• Recognise immediately in P&L
• For assets using revaluation model
• Reversal of impairment loss is treated exactly like an upwards revaluation.
• The reversal of any excess impairment loss originally recognised in P&L is also recognised in P&L.
• Further reversal will be recognised in Other Comprehensive Income (i.e. increases the balance in the Revaluation Surplus Reserve).

Cash Generating Units (CGUs)

Definition

• If it is not possible to calculate the recoverable amount for an asset (e.g. does not independently produce cash flows), then impairment testing must be performed for the CGU to which the asset belongs.
• A CGU is the smallest identifiable group of assets (including Goodwill) that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.

Carrying value of a CGU

• To calculate the carrying value of CGUs, shared assets (e.g. head office, goodwill, etc.) would need to be allocated to the CGUs, e.g. to that CGU that benefits or uses it the most, or proportionately.

Impairment of a CGU

• The impairment loss of a CGU needs to be allocated to the assets within the CGU.
• This allocation of impairment loss should not reduce an asset’s value below its recoverable amount.
• The loss is typically allocated in this order
1. To any assets that are obviously impaired (e.g. damaged, obsolete)
2. To goodwill allocated to the CGU
3. To other assets (whose values can be reduced further) on a pro rata basis (i.e. reducing the values of these other assets will not cause the values to drop below their recoverable amounts. Items such as cash, receivables, and payables are usually stated at net realisable values so cannot be reduced further).

Difference Between Downwards Revaluation and Impairment [my notes]

• Both revaluations and impairment testing can apply to the same assets.
• Both revaluations and impairment testing are separate, on-going requirements with their own processes and rules as specified in IAS 16 and IAS 36.
• It is not true that impairment is applied only to assets measured using a Cost Model, while downwards revaluation is the equivalent of impairment for assets using a Revaluation Model.
• Assets using a Revaluation Model can be impaired using the rules of impairment testing (i.e. comparing carrying value with the higher of FVLCTS and VIU).
• Assets using a Revaluation Model can ALSO be revalued downwards using the rules of revaluation (i.e. comparing carrying value with fair value).
• IAS 16 does not specify the frequency of revaluations. It just provides guidance to say that a revaluation is necessary if fair value differs materially with carrying value, and the larger the fair value volatility, the more frequent assets should be revalued.
• IAS 36 does not specify the frequency of impairment test (except for a few intangibles). However it gave examples of “indications” where the asset value might have declined materially, hence impairment testing should be done, e.g. decline in asset’s market value, changes in the environment the entity is operating in, changes in market conditions, change in use of the asset, etc.
• Think of them as two separate standards with different objectives
• The Revaluation Model in IAS 16 aims to make the carrying value of assets representative of their fair values throughout their time in the financial statements. This is somewhat like a “mark-to-market” requirement.
• The impairment testing requirement in IAS 36 aims to make sure that carrying values are not overstated, i.e. it acts as a ‘cap’ to to prevent companies from reporting asset values that are too high. Hence in a sense, IAS 36 does not care about whether your carrying value is understated, technically there is no impairment loss, and IAS 36 does not bother. The conditions specified in IAS 36 for when impairment testing should be done, also means that this is the standard that ensures that companies HAVE to test their asset values when there are material changes in the market environment which might cause their asset values to decline.

-END-

• IAS 19: Employee Benefits

SHORT-TERM EMPLOYEE BENEFITS

Requirement

• Recognise a Liability for employee benefits to be paid in the future for work already done
• Recognise an Expense when the employees’ services are used

Accounting Treatment

• Dr Employment Cost (e.g. wages) in Income Statement
• Cr Liability (e.g. accrued wages) in Balance Sheet

POST-EMPLOYMENT EMPLOYEE BENEFITS

Two types of pension schemes:

1. Defined contribution plan – Company contributes to a scheme (e.g. IRAs, 401(k))
2. Defined benefit plan – Company pays out benefits on retirement (e.g. typical private sector retirement pension plans)

Defined Contribution Plan

Accounting Treatment

• Pension contributions payable are expensed to P&L
• Balance Sheet will contain prepayments (asset) or accruals (liability) to account for timing mismatch between cash contributions and income statement expenses.

Defined Benefit Plan

Key Terms

• Current Service Cost
• Amount of pension entitlement that employees have earned in the current period.
• Accounting entries
• Dr Current Service Cost (Income Statement)
• Cr Pension Liability (Balance Sheet)
• Example calculation
• Say you need $100 in 5 years time to meet your employee benefits obligation.
• For each of the 5 years, you need to put in an amount (i.e. the current service cost), such that when compounded at the discount rate, each individual amount becomes $100/5 = $20. So the total would be $100.
• Hence at end of Year 1, current service cost = $20/(1+r)^4 (since there are only 4 years from end of Year 5 to end of Year 1).
• At end of Year 2, current service cost = $20/(1+r)^3
• …
• At end of Year 5, current service cost = $20.
• Past Service Cost
• Change in the pension liability (for employee service in past periods) due to changes in the plan benefits
• Accounting entries (e.g. if benefits are increased)
• Dr Increase in Past Service Cost (Income Statement)
• Cr Pension Liability (Balance Sheet)
• Note that if the new plan benefits only ‘vest’ after period (e.g. some category of employees need to serve another 2 years), the past service cost associated with those affected group needs to be spread over the vesting period.
• Interest Cost
• Increase in PV of defined benefit obligation due to the benefits payout being one period closer.
• Interest cost = Opening Pension Liability * Discount Rate
• The Discount Rate used should be the discount rate at the beginning of the period, and should take into account changes in the liability during the period. The change in the liability value due to the change in discount rate from the beginning to the end of the period, is incorporated inside actuarial gain/loss.
• Accounting entries
• Dr Pension Interest Cost (Income Statement)
• Cr Pension Liability (Balance Sheet)
• The Discount Rate needs to reference market yields of high quality corporate bonds, or in countries where there is no deep market in such bonds, government bonds.
• Expected Returns on Plan Assets
• This is the expected return (from dividends, capital gains, interest) less plan administration costs and tax payable by the plan.
• The expected return used should be the expected return at the beginning of the period, and should take into account changes in the assets during the period. The change in the asset value due to the change in expected return from the beginning to the end of the period, is incorporated inside actuarial gain/loss.
• Accounting entries
• Dr Pension Asset (Balance Sheet)
• Cr Expected Return on Plan Assets (Income Statement)
• Contributions Paid Into Plan
• Cr Cash
• Dr FV of Plan Asset
• Benefits Paid Out
• Cr FV of Plan Asset
• Dr PV of Pension Obligation
• Actuarial Gain/Loss
• Changes in value of Pension Asset / Pension Obligation due to changes in actuarial assumptions (e.g. retirement age, life expectancy, expected returns, etc.)
• Usually calculated as a balancing figure in the reconciliation equations below.
• Fair Value of Pension Asset
• Opening Balance
• + Expected Return on Plan Assets
• + Contributions Paid into Plan
• - Benefits Paid Out
• + Actuarial Gain/(Loss)
• = Closing Balance
• Present Value of Pension Obligation
• Opening Balance
• + Interest Cost
• + Past Service Cost
• + Current Service Cost
• - Benefits Paid Out
• + Actuarial Gain/(Loss)
• = Closing Balance

Accounting Treatment of Actuarial Gain/Loss

Problem with Actuarial Gains/Losses

• Recognising it in each period in the Income Statement will cause significant fluctuations in the reported profits because the actuarial gain/loss figures can be significant.

Two main approaches

1. Corridor Approach
• Calculate (A) = Greater of
• 10% of the PV of the Pension Obligation at the beginning of the year
• 10% of the FV of the Pension Asset at the beginning of the year
• Calculate (B) = Net cumulative unrecognised actuarial gains/losses at the end of the previous reporting period
• Estimate (C) = Expected average remaining working lives of the employees participating in the plan
• If (B) <= (A), no recognition of the actuarial gains/losses
• If (B) > (A), recognise ((B) – (A)) / (C) in the P&L, i.e. recognise the portion that exceeds the corridor, over the expected average remaining working lives of the employees participating in the plan.
• Note that there is a 1-year lag, i.e. the amount recognised in the current period is based on figures at the end of the previous period.
• For applying the corridor approach in the next period, add the current period’s net actuarial gain/loss to the cumulative unrecognised actuarial gains/losses.
2. Recognition in Full
• Recognise the actuarial gain/loss in full as they occur, in Other Comprehensive Income, which will flow to Retained Earnings, bypassing P&L.
3. Note that using the Corridor Approach will result in a reported figure in the Balance Sheet that excludes the cumulative unrecognised actuarial gains/losses. If there is a positive unrecognised actuarial loss, the Balance Sheet liability would be understated.

Accounting Treatment of Settlement and Curtailment

Key Terms

• Settlement is a payment made to plan participants to extinguish their right to future benefits.
• Curtailment is a reduction in pension liability by the company through plan amendments (e.g. restructuring)
• There is no clear distinction between curtailment and negative past service cost as yet in the accounting standards (see here).

Accounting Treatment

• Recognise gains/losses on settlement or curtailment when it occurs.
• Gain/loss will comprise
• Any resulting change in the PV of the Pension Obligation
• Any resulting change in the FV of the Plan Asset
• Any related unrecognised actuarial gains/losses and unrecognised past service cost (e.g. not yet vested)

Net Pension Liability / (Asset) Reported in Balance Sheet

Net Pension Liability / (Asset)

• PV of Pension Obligation
• - FV of Pension Asset
• + Unrecognised Actuarial Gain / (Loss)  [If there is an unrecognised gain, the liability should be higher, that's why it is added.]
• - Past Service Cost Not Yet Recognised (e.g. not yet vested) [the "derecognition" is happening right here! The past service cost not yet recognised is subtracted here because if you don't recognise it, the liability is lower. This also means that the past service cost that went into the computation of the PV of Pension Obligation is the fully vested past service cost, which must indeed be the case because else the actuarial gains/losses being the balancing figure, would capture the "non-vested past service cost" and would not be correct.]
• = Pension Liability / (Asset)

Asset Ceiling Test

• If there is a positive Net Pension Asset (as calculated above), the amount recognised in the Balance Sheet is the LOWER of that amount and the sum of
• Cumulative unrecognised net actuarial losses and past service cost (a positive number)
• PV of any refunds from the plan or reductions in future contributions (also a positive number)
• Note that the asset ceiling test must add the [positive number] cumulative unrecognised net actuarial losses and past service cost in order to push up the ceiling by an amount equal to the unrecognised losses and past service cost embedded in the positive net pension asset value. In this way, that ceiling wouldn’t be violated because of the unrecognised losses and past service cost. Without that term in the sum, the ceiling would be easily violated and value would switch to being the PV of the refunds. That would effectively “throw out” all those rules about not recognising some actuarial losses and past service cost because those rules can’t be implemented already (because if you do follow those rules, you will violate the ceiling and trigger that reset above). You can read BC78F for the official commentary on this. Basically they know its messy, and are looking to revamp this.
• There is a reasonableness cap placed on the reported value (i.e. you cannot recognise an asset simply because of unrecognised losses)

-END-

• IAS 17: Leases

Classification of Leases

• Finance leases (substantially all of the risks and rewards of ownership are transferred to the lessee)
• Operating leases (otherwise)
• Note that because Land has indefinite useful life, it is typically classified as an operating lease

Calculating Total Finance Charge over Lease Term

• Total minimum lease  payments (cash)
• - Cost of the asset (i.e. lower of fair value and PV of minimum lease payments)
• = Total finance charge

Accounting for Operating Leases

Accounting for Operating Leases as Lessee

• P&L
• Lease expense recognised in P&L.
• Note that lease expense is an accrual item, not a cash item. It is calculated as the total lease payments (cash, incorporating any discounts or deposits) under the contract, spread evenly over the lease term.
• Lease payment typically covers both interest and principal payments (just like a mortgage)
• Balance sheet
• Recognise an asset item (for pre-payments) or liability item (accrual for lease) due to the timing differences between cash payments and lease expense.

Accounting in Operating Leases as Lessor

• Continue to hold the asset in its books and depreciate as per normal.
• Recognise the rental as income, accrual item on the income statement.
• Differences in timing between cash and accrual of rental income is captured as either accrued income (asset) or deferred income (liability).

Accounting for Finance Leases

Accounting for Finance Leases as Lessee

• Carried on the Balance Sheet as a Non-Current Asset, and a Finance Lease Liability (as though the asset was bought but the purchase price is gradually paid back through the liability)
• Initial recognition
• Dr Non-Current Asset, Cr Finance Lease Liability with Lower of
• Fair value of asset; and
• Present value of the minimum lease payments.
• Subsequent treatment
• Depreciate the Non-Current Asset over the Shorter of
• Useful life of the asset; and
• Lease term (including any secondary lease term for less than market rent)
• Increase Finance Lease Liability (Balance Sheet) with accrued interest (Dr Finance Cost in P&L), and decrease Finance Lease Liability with cash repayments (Cr Cash). This is done in the same way as accounting for provisions under IAS 37.
• Note that if cash is paid in advance, then interest is calculated on the remaining balance, else interest is calculating on the starting balance.

Accounting for Finance Leases as Lessor

• If Lessor is not the manufacturer/dealer
• Remove the asset from its books
• Add a ‘Lease Receivable’ asset = PV of payments receivable under the lease + PV of residual value at the end of the lease if any
• Payments received are split between Finance Income (in Income Statement) and partial repayment of Lease Receivable (in Balance Sheet)
• If Lessor is the manufacturer/dealer
• Recognise sales revenue
• Lower of Fair Value and PV of future lease receipts discounted at a market rate of interest
• Cost of sale
• Carrying value of the asset – PV of any residual amount expected to be received by the Lessor at the end of the lease
• Recognise Finance Income as per usual.
• [My note: I don't see it in IAS 17 but I suspect that the Lessor will recognise an interest-generating receivable asset item for the item sold through a finance lease.]

Sale and Leaseback Transactions

First determine if the substance of the transaction constitutes a Finance Lease or an Operating Lease.

Sale and Leaseback (Finance Lease)

Two ways of accounting:

1. Account for the Sale/Disposal, then account for the Finance Lease
• First the sale,
• Dr Cash with sales price, Cr Non-Current Asset with carrying value, Cr Deferred Income [asset is removed from balance sheet]
• Deferred Income is credited with the amount by which the sale price exceeds the carrying value. This deferred income is amortised to P&L over the lease term.
• The reason why this is not immediately recognised in P&L is that this is essentially a secured loan transaction, the loan proceeds do not reflect the fair value of the asset hence are not the true sales proceeds.
• Next the Finance Lease
• Dr Non-Current Asset, Cr Finance Lease Liability with the lower of (FV and PV of future lease receipts) [asset is placed back onto the balance sheet].
2. No Sale Recorded
• No sale recorded because this is essentially a secured loan.
• Asset remains on the balance sheet.
• Record the “sale proceeds” as a Loan under Balance Sheet liability.
• Future repayments are to repay the loan and interest payments.
3. Note that the 1st method will result in a higher asset value because the carrying value is replaced by the FV which is usually higher, whereas the 2nd method does not change the carrying value. Nonetheless in terms of impact to the P&L, the higher depreciation charges in the 1st method will be offset with the release of deferred income into the P&L over the lease term.

Sale and Leaseback (Operating Lease)

Accounting for the sale (true sale, since it is not an operating lease)

• Remove asset from Balance Sheet
• If (fair value < carrying value), write down the carrying value to fair value, and immediately recognise the difference as a loss.
• Three scenarios
1. Sale price = fair value
• Recognise Gain/(loss) on disposal in P&L = (sale price – carrying value)
2. Sale price < fair value
• If lease rentals are below fair market cost, then the loss on disposal (if any) is deferred and amortised in proportion to the lease payments over the lease term.
• Else, recognise Gain/(loss) on disposal in P&L = (sales price – carrying value)
3. Sale price > fair value
• Recognise Gain/(loss) on disposal in P&L = (fair value – carrying value)
• The excess profit (sale price – fair value) is deferred and amortised over the lease term.
• Accounting entries
• Dr Cash with sale price
• Cr Non-Current Asset with carrying value
• Cr Income Statement with (fair value – carrying value)
• Cr Deferred Income with (sale price – fair value).

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• IAS 37: Provisions, Contingent Liabilities and Contingent Assets

Provisions

Definitions

• Liability
• Present obligation as a result of past events
• Expected to result in an outflow of economic benefits
• Reliable estimate can be made of the amount
• Provision
• Liability of uncertain timing or amount

Recognition Criteria for a Provision

• Present obligation (legal or constructive) as a result of past events
• Note that for an environmental provision can only be recognised if the environment damage has already happened.
• Probable (> 50% probability)
• Reliable estimate can be made of the amount

Accounting Treatment of Provisions

• Increase in provisions is charged to Income Statement, and recognised in the Balance Sheet
• Future movements in provision is recorded in Income Statement.
• For provisions that are PV-ed, the provision increases each year as the discount is unwound. The discount that is unwound (i.e. the increase in liability) is recorded as a Finance Charge in the Income Statement. Example:
• Expected outflow of $110 at end of year 1, and outflow of $121 at end of year 2.
• At time 0
• Initial value = PV at 10% discount rate = 110/1.1 + 121/(1.1^2) = 100 + 100 = 200.
• Initial recognition, Dr Provision (Income Statement), Cr Provision (Balance Sheet) with 200.
• 1 year later
• Finance charge = Interest rate * Provision value = 10% * 200 = 20.
• Dr Finance Charge (Income Statement), Cr Provision (Balance Sheet) with 20.
• Outflow of 110, so Cr Provision (Income Statement), Dr Provision (Balance Sheet) with 110.
• Closing Provision value = 200 + 20 – 110 = 110.
• 2 years later
• Finance charge = Interest rate * Provision value = 10% * 110 = 11.
• Dr Finance Charge (Income Statement), Cr Provision (Balance Sheet) with 11.
• Outflow of 121, so Cr Provision (Income Statement), Dr Provision (Balance Sheet) with 121.
• Closing Provision value = 110 + 11 – 121 = 0.
• Special case: Compulsory costs related to Non-Current Assets
• E.g. clean up costs at the end of the asset’s life
• Instead of debiting Income Statement, the Non-Current Assets (in Assets) is debited, i.e. the cost of the asset increases. Hence the clean-up cost is capitalized into the cost of the asset.
• Accounting entries
• Dr Non-Current Assets (Balance Sheet)
• Cr Provision (Balance Sheet)
• The non-current asset is then depreciated per normal.
• The Finance Charge affects the Provision account, not the Non-Current Asset account.

Valuation of Provisions

• For a single obligation, best estimate of most likely outcome.
• For a large number of obligations, calculate the final expected value of the net obligation.
• If time value of money is material, provisions should be PV-ed using a pre-tax market rate that reflects the risk of the liability.

Contingent Liabilities

Definition

• Possible obligation that arises from past events
• Occurrence not wholly within the control of the entity.
• Either not probable (<= 50% probability) or amount cannot be measured with sufficient reliability

Accounting Treatment

• Not recognised in Balance Sheet or recorded in the ledger accounts.
• If the probability is ‘possible’, should be disclosed in the notes
• If the probability is ‘remote’, can be ignored.

Contingent Assets

Definition

• Same as contingent liability but an asset instead.

Accounting Treatment

• If the probability is ‘probable’, should be disclosed in the notes [note that this is stricter than for contingent liabilities. For contingent assets, it still cannot be disclosed when it is 'possible', only when it is 'probable'] 
• If the probability is ‘possible’ or ‘remote’, can be ignored.
• If the probability is ‘virtually certain’, it should be recognised as an asset.

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• IAS 24: Related Party Disclosure

Related Party Transaction

• A related party transaction is a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged.

Related Party

A party is related to an entity if

• The party controls the entity, or is controlled by it.
• It has significant influence over the entity.
• It has joint control over the entity.
• The parties are under common control (i.e. both Subs)
• The party is an associate.
• The party is a joint venture in which the entity is a venturer.
• The party is a member of the key management personnel of the entity or its parent.
• The party is a close family member of any of the above.

Exemptions (i.e. not considered related parties)

• Two entities with a common director or common member of key management personnel (if the director/key management jointly controls both entities, then the two entities are related)
• Two entities where a member of key management personnel of one entity has significant influence over the other entity
• Two venturers that share joint control over a joint venture
• Providers of finance (e.g. bank, bondholders), trade unions, public utilities, Government departments and agencies
• Customers, suppliers, franchisers, distributors or other agents with whom the entity transacts a significant volume of business.

Disclosure Requirements

For each category of related parties:

• Nature of relationship
• Amount of transactions (sales / purchases)
• Amount of outstanding balances
• Provisions for doubtful debts and expense recognised in respect of irrecoverable debts due

General disclosure requirements

• Compensation to key management personnel
• short-term employee benefits
• post-employment benefits
• other long-term benefits
• termination benefits
• share-based payment
• Parent and ultimate parent
• Name of Parent, and if different, the ultimate controlling party.

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• IAS 10: Events After the Reporting Period

Scope

• This standard deals with events that occur between the end of the reporting period, and the date when the financial statements are authorised for issue.

Accounting Treatment

• For ‘Adjusting Events’, adjust the financial statements
• For ‘Non-Adjusting Events’
• If it does not impact the entity’s status as a going-concern, only disclose the material events (i.e. events that would influence the economic decisions of financial statements users)
• If it impacts going-concern, present the financial statements on a break-up basis.

Adjusting Events Examples

• Court case settlement: The settlement after the reporting period of a court case that confirms that the entity had a present obligation at the end of the reporting period. The entity adjusts any previously recognised provision related to this court case in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets or recognises a new provision.
• Impairment of assets: The receipt of information after the reporting period indicating that an asset was impaired at the end of the reporting period, or that the amount of a previously recognised impairment loss for that asset needs to be adjusted. For example:
• the bankruptcy of a customer that occurs after the reporting period usually confirms that a loss existed at the end of the reporting period on a trade receivable and that the entity needs to adjust the carrying amount of the trade receivable (e.g. bad debt provision);
• the sale of inventories after the reporting period may give evidence about their net realisable value at the end of the reporting period (e.g. should be written down).
• Finalization of prices: The determination after the reporting period of the cost of assets purchased, or the proceeds from assets sold, before the end of the reporting period.
• Finalization of employee benefits: The determination after the reporting period of the amount of profit-sharing or bonus payments, if the entity had a present legal or constructive obligation at the end of the reporting period to make such payments as a result of events before that date.
• Discovery of fraud: The discovery of fraud or errors that show that the financial statements are incorrect.

Non-Adjusting Events Examples

• Declaration of dividends
• Destruction of a plant by fire
• Fall in market value of investments
• Business combinations
• Discontinuation of an operation
• Restructuring
• Shares issuance
• Changes in tax rates
• New contracts resulting in new liabilities

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