 IFRS FOR SME’S

ISSUE March VOLUME 2 YEAR 2010

 MICROFINANCE

 OIL DYNAMICS

 MERGERS AND ACQUISITIONS

 MOMENTUM INVESTING

RISK MANAGEMENT
Fin$ight
The Finance Club of Asian Institute of Management, Manila

Challenges
ahead for MFIs

Microfinance
 Contents
1
VaR Unleashed: A continuing series on VaR and its effects
on financial crisis
From VaR’s success a model for risk measurement to its flaws and why we still need it!
by Lakshminarasimhan Sundararajan

2
The Changing Oil Dynamics
From inventory model to OPEC spare capacity to term structure fluctuations, the oil pricing
dynamics have been changing constantly as marginal returns on investment fall. But as
always, fundamentals hold the key to pricing.
by Mona Khetan

4
Microfinance Institutions: The Challenges Ahead
60 % of the India’s population is dependent on agriculture and it contributes up to 18% to
the national economy. The changing land patterns and the unstable cycles have reduced
micro lending to small farmers. This article presents the challenges MFI’s should overcome
to promote AGRI Micro Finance
by Hari Vardhan Kuna

5
Upcoming Events at AIM Finance Club

6
Acquisition through Stock or Cash?

Shall an offer be made with stock or cash? What are the concerns of Buyers and Sellers and
who takes away chunk of Shareholder Value Added (SVA)?
by Rajan Pahuja
8
Momentum Investing: Riding the wave
The prospect of earning abnormal profits due to this market anomaly has attracted many
asset managers to pursue momentum investing which has created a wide spread
competition in this arena.
by Anuj Goel

9
IFRS for Small & Medium Enterprises
Preparing Financial Statements in accordance with IFRS or full US GAAP is an expensive and
time-consuming process with extensive disclosure requirements. This article describes IFRS
for SMEs that have been prepared specifically for SMEs, their benefits, drawbacks and issues
to consider for the transition to IFRS for SMEs.

by Syed Mehdi Kalbe

VaR Unleashed: A continuing
series on VaR and its effects on
financial crisis
“There are known
knowns. These are things
we know that we know.
There are known
unknowns. That is to say,
there are things that we
now know we don’t know.
But there are also
unknown unknowns.
These are things we do
not know we don’t know.”
–Donald Rumsfeld
What made VaR successful as a
model? At the time when Risk Metrics
designed VaR, there was no models
that could apply to compare risks of
various assets as well as the firm wide
risk. VaR solved all that by coming up
with a dollar value that a portfolio
could stand to lose 99% of the time in
the given time frame. Every time a
new asset was added to the portfolio,
VaR could be recalculated and new
level of risk assessed. The reason for
VaR ‘s prevalence across the financial
spectrum, is when JP Morgan decided
to give it away by making it open
source and even asking other experts
to contribute to it. Everyone, from a
trader to a CEO liked the simple dollar
value estimate for risk; even the SEC
was convinced so much that it
required financial intermediaries to
disclose their VaR’s in the annual
reports. When VaR was included as the
preferred method of measuring market
risk in Basel II banking norms it
became institutionalized.
So what are the flaws in VaR? It’s the
unpredictability of the amount of loss
the 1% of time that is the most
dangerous with VaR models. It’s a
Black swan event that causes the risk
model to fail. VaR flaws lies in the fact
that it depends on historical data to
predict the losses. A black swan event
(which has a few in a million chances
in history of appearing) creates a
problem in the model. Most of the
worst case risk scenarios were
modelled for example after the 1987
stock market crash in the US which
resulted in the Dow Jones lost almost
22% of its value in a day, i.e. most
people were betting on the fact that no
other event would happen that would
be worse than this happens to be the
biggest fallacy. For example, a credit
default swap is essentially an
insurance the company won’t default
on its borrowings. Many investment
banks/financial firms made gains by
selling CDS to investors, but the
chance of paying the insurance was
thought to be very small(about one in
a million), and since it was beyond the
99%, VaR number did not show the
true extent of the riskiness of the
financial institution.
In my opinion, even though the idea of
VaR number seems to create a whole
lot of problems, its importance in
measurement of risk 99% of the time
cannot be diminished. After all we
need to be able to quantify risk in
order to see the direction of risk our
portfolio is moving to. A story goes
that Goldman Sachs lost the least
during the crisis because they looked
at direction at which their portfolio risk
was proceeding and not just at the
numbers. The ideal role of the VaR is
to provide managers with some intel
about the situation in hand just as in a
war then they have to make judgment
calls based on all available information
rather than blindly following a dollar
figure.
Lakshminarasimhan Sundararajan, FRM
Level 1 Candidate, MBA 2010, Interests in
Economics, Risk Management and Forex.
1
The Changing Oil Dynamics
Like most
commodity markets,
it is the supply and
demand dynamics
that determine the
price of oil.
However, unlike
other commodities, oil’s non
renewability and its high reserve
concentration in a few countries make
the supply of oil highly vulnerable. In
contrast, on the demand side, the
world’s sustained dependence on oil
has kept the demand curve pretty
much upward sloping. This makes oil a
very sought after commodity.
The story was not the same a few
decades back though. At that point of
time, most thought that despite oil
being non-renewable, it’s abundant. In
1956, when King Hubbert proposed his
“oil peak theory” stressing that US 1 oil
production would peak by 1970, his
prediction received a lot of criticism.
However, US oil production peaked at
around 10 million barrels per day in
1970 and has been on a downward
1
US oil production is just a proxy, the bell shaped
production curve goes for every oil field, though the
peak time would differ.
trend since then. However, as we
notice in the chart below, the trend
wasn’t clear enough until 2000 and
most people came to agree with it only
around 2004.
This does not imply that we are not
running out of oil, not anytime soon.
The downward trend however implies
that we need to invest more and more
to extract every extra barrel of oil now
i.e. diminishing marginal returns on
investment. This changes the
dynamics for oil pricing.
Historically, inventory model worked
(the lower the inventory, the higher
the price and vice versa) for
determining the price of oil. The
relationship however broke down in
2004 when a sharp fall in spare
capacity led to unprecedented rise in
prices. Spare capacity 2 became a
dominant driver for oil prices since
then.
Around the same time, we also notice
a prominent shift in the oil forward
2
OPEC countries do not produce oil to their full
potential but according a quota assigned to them. This
generates spare capacity which can be brought to
production within a short period of time in case of
high demand.
2
curve from contango 3 to In effect, the reasons driving oil prices
backwardation as the convenience have been changing constantly. The
yield for oil increased, reflecting the question is how do we capitalize from
expected low scarcity of the oil today these? The bottom-line is to never
versus sometime in the future. loose sight of the underlying
(Ideally, backwardation is an unlikely fundamentals. For example, the recent
scenario when it comes to recession had the power to drive down
commodities given the associated oil prices as low as $40 per barrel
storage costs.) despite supply concerns. Moreover,
one could reap benefits from a
Finally, OPEC’s influence in dictating sustained backwardation by buying
the terms has substantially increased. long term (low price) and then cashing
Any signal from them can change the in near term (high price) due to the
course of oil price. We also witnessed downward sloping term structure. And

15 $/barrel
Crude Oil M1-M3 Spread
10
Backwardation
5

-5

-10
Contango

-15
1986 1989 1992 1995 1998 2001 2004 2007
Source: Bloomberg

a long list of alternate energy sources last but not the least, we could all
as substitutes to oil, but none of them benefit if we are committed to using
so far has been a fitting reply, energy judiciously.
especially when it comes to
transportation. For example, though
ethanol is a close substitute to
gasoline, its production poses threat to
food scarcity and its transport to retail
outlets isn’t as easy as it is for
gasoline.

Mona Khetan, FRM, MBA 2010, CFA level

II candidate, interests in Risk
3 Management, Merger and Acquisitions and
Contango implies an upward sloping forward curve
Commodities
while backwardation implies a downward sloping
curve.

3

Microfinance Institutions: The
Challenges Ahead
Agricultural contribution to Indian
economy is about 18%, involving
about 60% of the population.
According to Ravallion and Datt
(1996), 84.5 percent of the substantial
poverty reduction in India during 1951
to 1991 was due to agricultural
growth. These numbers highlights how
important agriculture is for a country
like India.
The landholding per household has
decreased considerably in the last 30
years. Marginal land owners (owning
less than one hectare) has increased
from around 40% in 1971 to more
than 70% in 2003 and is increasing
further. The changes in the
landholding patterns have affected the
way these institutional creditors
(traditional banks) lend over a period
of time. Institutional creditors
contributed for 7.2 percent of the total
cultivator debt in 1951 and has
increased its share to 66.3% in the
year 1991.However, the share of the
institutional credit agencies has come
down 57 percent in 2002.
If you consider that agricultural growth
was one of the main reasons for
poverty reduction in India, one of the
main supporting pillars for the poverty
reduction was the Institutional credit
to farmers. Institutional lenders lend
money by having land as the
collateral. But with the changing
patterns of the landholdings in the
recent times institutional lenders are
losing ground in rural India. Their loss
is the gain of moneylenders (non
institutional). This trend should not be
welcomed as many moneylenders
exploit the situation of the poor
farmers due to the non availability of
the credit from the institutional
lenders.
Micro Finance Institutions (MFIs) are in
the forefront for poverty reduction in
many developing countries. MFIs have
confined themselves essentially to
rural micro enterprises as they catered
to the requirements of the non-farm
sector and satisfied only immediate
consumption needs. Micro enterprises
or non - farm business activities
generate regular income and permit
the beneficiaries of the credit facilities
to repay in frequent and small
instalments. Farm activities on the
other hand have a longer and less
stable, unpredictable cycles. MFI’s
loans are in proportion to savings, it
requires frequent and faster
repayments higher than market
interest rates and insistence on regular
group meetings. All these factors
make MFI loans unattractive to
farmers’ needs. Income accruals from
agriculture are significantly influenced
by risks associated with natural factors
such as rainfall and other climatic
conditions; as a result very few MFI’s
come forward to lend exclusively
agricultural activities. Only 8% of the
total INR 75 billion was lent to finance
agriculture.
The concerns of both the institutional
lenders and the MFIs are genuine, but
by not providing access to the
marginal farmers, Indian institutions
are ignoring the very sector that have
contributed the most for poverty
reduction. To overcome this both MFIs
and institutional lenders should come
up with new forms of lending that will
renew the farm credit once again. In
past 2-3 years there are few initiatives
that were taken different pockets of
the country. But these initiatives are
facing challenges in replicating them
because of the heterogeneity involved
in the nature of the agriculture
throughout the country. Now the game
for MFIs and institutional lenders lies
in customized innovation, since the
needs of different farmers of different
regions are distinct, and contribution
for poverty reduction in the country.
Hari Vardhan Kuna, MBA 2010, Interests
in Microfinance and Risk Management
4
Upcoming Events at AIM risk and return through
Finance Club perspective of a day trader.

1. A talk by Prof. Roberto Galang

MSc Economics Oxford
University on 8th March, 2010
on the practical applications on
economics/econometrics as a
future career. This is especially
for those who want to apply
their microeconomics skills after
AIM, both from a government /
policy-maker’s viewpoint, as
well as for those interested in
private sector positions.

2. The CFA Society of the

Philippines in cooperation with
Institute of Strategy & Valuation
presents a seminar on "Why
Bruce Lee would have been
great at valuation” Varying
Techniques for Superior
Investing By MR. JOEL LITMAN,
Managing Director, Equity
Analysis & Strategy, Inc.
Thursday, March 11, 2010,
2:30PM to 5:30PM

Address: Oakwood Premier Joy

Nostalg Center, 17 ADB Avenue,
Ortigas Center, Pasig, Metro
Manila, Philippines.

3. Virtual Stock Exchange:

Students try out different
strategies to maximise the
equity portfolio gain on virtual
stock exchange software dealing
US stocks. The competition runs
for a month starting 8th March,
2010; standing and portfolio of
each member can be seen by
anyone. This game makes
students understand concepts of

5
Acquisition through Stock or
Cash?
In a an acquisition with cash deal, the
roles of two parties are clear but in a
stock deal, it is less clear who is the
buyer and who is the seller.
In cash transactions, acquiring
shareholders take on the entire risk
that expected synergy value
embedded in the acquisition premium
will not materialize. In stock
transactions, the risk is shared with
the selling shareholders; more
precisely, the synergy is shared in the
proportion to the percentage of the
combined company the acquiring and
selling shareholders each will own.
For instance, Buyer Inc. wants to
acquire the competitor Seller Inc. The
market capitalization of Buyer is $5
billion made up of 50 million shares
priced at $100 per share. Seller’s
market capitalization stands at $2.8
billion-40 million shares each at $70.
The managers of Buyer estimate that
merging the two companies can create
synergy value of $1.7 billion by
acquisition of Seller. They announce
that an offer to buy all the shares of
Seller at $100 per share. The value
placed on the Seller is therefore is $4
billion, representing a premium of $1.2
billion over the company’s
preannouncement market value of
$2.8 billion.
The expected net gain to the acquirer
from the acquisition-called as
Shareholder Value Added (SVA) is the
difference between the estimated
value of the synergies obtained
through the acquisition and the
acquisition premium. So if Buyer
chooses to pay cash for the deal, then
SVA for its shareholders is expected
synergy of $1.7 billion minus the $1.2
billion premium, of $500 million.
But if Buyer decides to finance the
acquisition by issuing new shares, the
SVA for the existing shareholders will
drop. Let’s assume that Buyer offers
one of its shares for each of the
Seller’s shares. The new offer places
the same value on the Seller as did
the cash offer. But upon the deal’s
completion, the acquiring shareholders
will find that the ownership in Buyer
has been reduced. They will own only
55.5% of the new total of 90 million
shares outstanding after the
acquisition. So their share of the
acquisition’s expected SVA is only
55.5% of $500 million, or $277.5
million. The rest goes to the Seller’s
shareholders, who are now
shareholders in an enlarged Buyer Inc.
Fixed value or Fixed number of
shares
Boards and shareholders must do
simply more than stock or cash while
making or accepting an offer.
Companies can either issue a fixed
number of shares or they can issue a
fixed value of shares.
Fixed shares: The number of shares to
be issued is certain, but the value of
the deal may fluctuate between the
announcement of the offer and the
closing date, depending on the
acquirer’s share price. Both parties are
affected, but changes in the acquirer’s
price will not affect the proportional
ownership of the parties in the
combined company.
Fixed value: In these deals, the
number of shares issued is not fixed
until the closing date and will depend
on the prevailing price. As a result, the
proportional ownership of the ongoing
company is left in doubt until the
closing date. Let’s go back to Buyer
and Seller Inc. Suppose that Buyer has
made stock offer and its share has
fallen exactly by the premium it is
paying to the Seller- from $100 to $76
per share. At this price in fixed value
deal, Buyer has to issue 52.6 million
6
shares to give Seller’s shareholders $4
billion worth. But that leaves Buyer
with just 48.7% of the combined
company as compared to 55.5% they
would have had in the fixed-share
deal.
Questions for the acquirer
There are primarily three questions.
First, are the acquiring company’s
shares undervalued, fairly valued, or
overvalued? Second, what is the risk
that the expected synergies need to
pay for the acquisition premium will
not materialize? The answer to these
questions will help in making the
decision between cash and a stock
offer. Finally, how likely is it that the
value of the acquiring company’s
shares will drop before closing? The
answer to this question should guide
the decision between a fixed-value and
a fixed-share offer. Let’s take each
question in turn:
Valuation. If market is undervaluing
the acquirer’s shares then it should not
issue the new shares to finance the
transaction because that would
penalize the current shareholders.
When a company issues stock to
finance the transaction, it may give a
signal to the market that managers
think the stock is overvalued and stock
may fall after the information is
disseminated. Acquirer may believe
that its shares are undervalued, but in
real world, it is not easy to convince a
disbelieving seller to accept fewer but
“more undervalued” shares. In this
case it is logical course to proceed with
the cash offer.
Synergy Risks. A really confident
acquirer would pay for acquisition with
cash so that shareholders would not
have to give any of the anticipated
merger gains, synergy, to the acquired
company’s shareholders. But if the
managers think that the risks are
substantial, they can be expected to
try to hedge their bets by offering
stock. By diluting the ownership
interests, they will also limit the
partition in the losses incurred. Hence,
stock offer sends two powerful signals
to the market: that the acquirer’s
shares are overvalued and that its
management lacks confidence in the
acquisition.
Pre-closing market risk: Through a
research by Journal of Finance it has
been found that more sensitive the
seller’s compensation is to changes in
the acquirer’s stock price, the less
favourable is the market’s response to
the acquisition announcement. Hence
the greater the potential impact of
pre-closing market risk, the more the
important it is for the acquirer to
signal its confidence by assuming
some of the risk.
Questions for the seller
In case of a cash offer, the selling
company’s board faces a fairly
straightforward task. It just has to
compare the value of the company as
an independent business against the
price offered. The only risks are that it
could hold out for a higher price or
that management can create a better
value if company remained
independent. For example, Buyer bid
for $100, representing a 43%
premium over the current price of $70
of Seller. Let us suppose that they can
get a 10% return by putting the cash
in investments with similar level of
risk. After five years, the $100 will
compound to $161. If the bid were
rejected, Seller will have to earn 18%
return on its currently valued $70
share to do as well. So uncertain a
return must compete against a bird in
the hand. The questions Seller needs
to answer are: How much is the
acquirer worth? How likely is it that
the expected synergies will be
realised? and, How great is the pre-
closing market risk?
Rajan Pahuja, MBA 2010, CFA level III
candidate, interests in Fundamental
Research (Equities and Derivatives),
Merger and Acquisitions and
Macroeconomic Events
7
Momentum Investing: Riding the
wave
Momentum is one of the most
challenging asset pricing anomalies in
modern finance literature. Momentum
implies that stocks with high short-
term past returns (3 to 12 months)
will continue to outperform the stocks
with low short term past returns, It
provides the investment managers
with a trading strategy whereby they
can buy past winners and short sell
past losers and expect to earn extra-
normal returns.
stocks in the US market from 1951-
2005, which showed that a consistent
strategy of buying the best performers
(top 10%) over the previous year
returned 15.2%; and selling the worst
performers (bottom 10%) returned
only 3.4%.
The abnormal profitability cannot be
explained by the existing multifactor
models like Arbitrage Pricing Theory
(APT) and macroeconomic-based risk
explanations, which compensate the
investor with risk adjusted returns. It
is believed that the outperformance of
the assets can be attributed to the
irrational behavior of investors
explained by the behavioral finance.
Behavioral finance states that
psychological characteristics of
investors such as bounded rationality
and biased expectations result in this
irrational behavior which in turn
creates a market anomaly of
momentum in stocks.

The prospect of earning abnormal

profits due to this market anomaly has
attracted many asset managers to
pursue momentum investing which
This strategy was first documented by
has created a wide spread competition
N. Jegadeesh and Titman (1993) for
in this arena. A wide range of
the US market. They define
investment strategies built on
momentum in terms of average
momentum has netted record capital
unadjusted short-term past returns.
flows, raising the possibility that these
Their study shows that stock returns
anomalies get arbitraged away. The
exhibit momentum behaviour at
key to continued success will be to
intermediate horizons. A self-financing
spot these anomalies well before the
strategy that buys the top 10% and
competition, identify appropriate entry
sells the bottom 10% of stocks ranked
and exit points of trading on
by returns during the past 6 months,
momentum, and act with utmost
and holds the positions for 6 months,
discipline.
produces profits of 1% per month.

The empirical evidence from the

practitioner studies also show that
stocks with specific characteristics as
mentioned had outperformed
consistently, over the time. The best
recent performers had outperformed
Anuj Goel, MBA 2010,CFA level III
the worst recent performers. JP
candidate, interests in Corporate Finance,
Morgan conducted a study on the 12 Mergers and Acquisitions, and Capital
month returns obtained by 3000 markets.

8
IFRS for Small & Medium
Enterprises
The purpose of financial reporting is to
provide financial information for its
users. In any accounting text, you will
find the statement, “the benefit
provided by information should be
greater than the cost of provision.”
Compliance with Generally Accepted
Accounting Principles (GAAP) or full
International Financial Reporting
Standards (IFRS), which were
prepared for large publicly listed
corporations, requires complex
accounting treatments and extensive
disclosure requirements, making full
compliance quite expensive. Thus,
private small and medium sized
enterprises (SMEs) generally incurred
high costs of contracting professional
accounting firms and external auditors
in preparing complex financial
information that may not even be fully
understood by the main user, the
owner.
Thus, there was a need for a different
set of simpler standards for SMEs and
to fulfil this need the International
Accounting Standards Board (IASB)
published IFRS for SMEs on the 9th of
July 2009. As compared to full IFRS or
the US GAAP, the IFRS for SMEs have
simpler accounting standards and
fewer disclosure requirements, which
are more relevant to these small and
medium enterprises. Stressing on the
simplicity and fewer disclosure
requirements, the full US GAAP
exceeds 10,000 pages1, full IFRS is
about 2,700 pages, while IFRS for
SMEs is a mere 230 pages. Due to the
simplicity and reduction in time taken
to comply with these new standards,
adopting IFRS for SMEs would lead to
cost reductions as well as provide
information that is meaningful and
relevant to key users.
An added benefit is for private
companies that have foreign
businesses and thus need foreign
financing. It will be easier for such
companies to prepare statements in
accordance with IFRS for SMEs, which
are accepted globally, rather than
having to prepare another set of
financial statements in the local GAAP
of the foreign lender.
The IASB defines SMEs as entities that
do not have public accountability but
do publish general purpose financial
statements for external users such as
the owners of a privately owned
company, lenders and tax authorities.
Not having public accountability
implies its debt and equity instruments
are not traded on a public financial
market.
One of the main drawbacks is that the
standards do not offer a choice
between the FIFO and LIFO method of
inventory costing (while full IFRS offer
a choice between LIFO and FIFO, as
long as the principle of consistency is
applied). The FIFO method of
accounting leads to lower cost of
goods sold (as compared to LIFO
method) during times of rising costs,
thus increasing reported profits,
resulting in higher business tax.
In deciding to switch to IFRS for SMEs,
in my opinion the most important
issues an SME will face will be during
the transition stage. Some of the
considerations for transition include
guidance on first time adoption,
acceptance by key user of financial
statements, personnel training,
modifications to internal control
systems, communication to
stakeholders such as lenders and
suppliers and acceptance by external
auditors.
For first time adopters, IFRS for SMEs
require full retrospective adjustment.
As an example, an entity adopting
IFRS for SMEs for the first time in its
2010 financial statements must:
• Prepare an opening
statement of financial
9
 position (balance sheet) at
the transition date (January DID YOU KNOW ...
1, 2010) in accordance with
IFRS for SMEs. Comparative
information for the previous
year must also comply with
IFRS for SMEs.
…that the lowest price for a barrel of oil
• Make adjustments due to was approximately 15 dollars (calculated
transition from previous in 2006 terms) in the year 1930.
GAAP or IFRS. Most can be
made directly to retained
earnings. …that the Philippines is one the best in
• Consistently apply IFRS for
SMEs. The standards that
the world in terms of its microfinance
need to be applied are those environment. Its ranks 3rd after Peru
that were in effect at the and Bolivia in a study done by the
date of the closing statement
Economist Intelligence Unit.
of financial position,
December 31, 2010.
• Prepare financial reports for
the period ending December …the first time terms ‘bull’ and ‘bear’
31, 2010.
• In the notes, provide
were used to describe investors was in
reconciliations between IFRS the book, “Every Man His Own Broker”,
for SMEs and previous GAAP published in 1775 by Thomas Mortimer.
(or IFRS)

There is a general exemption from

retrospective application if it is …that a study conducted in 2000 by
impracticable for the company. To
Lehman Brothers, revealed that, on an
facilitate transition, there are certain
other exemptions available which are average, large M&A deals cause the
outside the scope of this article. domestic currency of the target
SMEs represent approximately 95% of corporation to appreciate by 1% relative
all companies2, and this excellent
initiative by the IASB could potentially
to the acquirers.
cater to the lower cost – more relevant
information demand of this huge
potential target market.

References:
1. www.allbusiness.com/education
-training/continuing-
education/11416715-1.html
2. www.iasb.org/News/Press%20R
eleases/IASB%20publishes%20I
FRS%20for%20SMEs.htm
3. www.iasplus.com

Syed Mehdi Kalbe, ACCA Associate, MBA

2010, interests in Corporate finance, M&A,
and Capital Markets.

10
Fin$ight and Finance Club, AIM
are registered with SSAR office,
Asian Institute of Management,
Makati City, Philippines.

11