Financial Statement Analysis Review

Weighting 13% to 17%

 Financial Statement Analysis Review

Financial Statement Analysis (1):

❑ Introduction to Financial Statement Analysis
❑ Financial Reporting Standards

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 Introduction to Financial Statement Analysis
Roles of Financial Statement Analysis Auditor/Audit Opinion
▪ Use financial statements and other information to make ▪ Independent review
economic decisions ▪ Reasonable assurance statements are
▪ Evaluate past performance and current financial position presented fairly, free from material error
▪ Form opinions about company’s ability to earn profits, ▪ Conformity with accounting standards,
generate cash flow consistency and reasonableness of
accounting methods and estimates
▪ Sarbanes-Oxley: Opinion on internal
Financial Statement Analysis Framework controls (U.S. only)
1. Purpose and context
2. Collect data Unqualified (clean) opinion
3. Process data
4. Analyze/Interpret data Qualified opinion
5. Develop conclusions/recommendations
6. Follow up Adverse opinion

Disclaimer of opinion

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 Introduction to Financial Statement Analysis
Income Statement Balance Sheet
▪ Net income = revenues less expenses (Statement of financial position)
▪ Accrual based using the matching principle ▪ Assets = liabilities + stockholders’ equity
▪ Might not equal cash flow ▪ Assets = economic resources controlled by the company
▪ Dynamic statement ▪ Liabilities = amounts owed
▪ IFRS: May combine with comprehensive income ▪ Stockholders’ equity = owners’ investment + retained earnings

Statement of Cash Flows Statement of Comprehensive Income

▪ Cash in and cash out Changes in equity from transactions and
▪ Cash flow from: nonowner sources (excludes share issues,
– Operations buybacks, and dividends)
– Investing
– Financing Statement of Stockholders’ Equity
▪ Closing cash = opening cash + change in cash for period ▪ Stock at par
▪ Additional paid in capital
MD&A and Footnotes ▪ Issuance and repurchases
Help explain the financial statements ▪ Changes in retained earnings
Extra information (on primary statements) ▪ Other comprehensive income
Significant choices or methods, estimates, and assumptions used ▪ Dividends

© Kaplan, Inc. 4
 Introduction to Financial Statement Analysis

Complete questions: FR1 – FR6

Time allocated: 7.5 minutes

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Approximate minutes remaining

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 Introduction to Financial Statement Analysis

FR1. If the financial statements contain material errors and deviate

from the applicable accounting principles, the auditor is most likely to
issue a(n):
A. unqualified opinion.
B. qualified opinion.
C. adverse opinion.

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 Introduction to Financial Statement Analysis

FR2. Which of the following is least likely to be found in the

Management Discussion and Analysis section of the financial
statements?
A. Funded status of the defined benefit pension plan.
B. Discussion of critical accounting policies and estimates.
C. Trends, events, and uncertainties affecting liquidity, capital
resources, and results from operations.

Funded status appears on balance sheet or in financial statement notes.

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 Introduction to Financial Statement Analysis

FR3. Producing adjusted financial statements, ratios, and

common-size statements is associated with which step of the
financial statement analysis framework?
A. Collect data.
B. Process data.
C. Analyze and interpret data.

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 Introduction to Financial Statement Analysis

FR4. Which of the following activities is least likely to be considered a

role of financial reporting and analysis?
A. Evaluating a subsidiary of a parent company.
B. Deciding whether to extend credit to a customer.
C. Evaluating the performance of a company’s auditor.

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 Introduction to Financial Statement Analysis

FR5. Which of the following statements regarding auditors is

least accurate? A company’s auditors:
A. are employed by the board of directors.
B. certify that the financial statements are free from error.
C. have a duty to ensure that accounting estimates used are
reasonable.

Provide reasonable assurance

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 Introduction to Financial Statement Analysis

FR6. Which of the following statements would be least accurately

described as supplemental information to the financial statements?
A. Proxy statements.
B. Quarterly or semiannual reports.
C. Statement of comprehensive income. Required financial statement

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 Financial Reporting Standards

International Accounting Standards Board

▪ Standards form International Financial Reporting Standards (IFRS)
▪ Adopted by the EU in 2005

Goals:
1. Development of high quality, transparent, and enforceable global standards
2. Promote application of standards
3. Take into account the special needs of:
▪ Small and medium entities
▪ Emerging markets
4. Convergence of national and international standards

Financial Accounting Standards Board

▪ Standards form U.S. Generally Accepted Accounting Principles (U.S. GAAP)
▪ Aims: Useful, relevant, reliable, consistent, and comparable
▪ SEC deems FASB standards authoritative

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 Financial Reporting Standards
Required Reporting Elements Fundamental Principles
▪ Assets ▪ Fair presentation
Objective: Fair Presentation
▪ Liabilities ▪ Going concern
▪ Financial position ▪ Equity
▪ Financial performance ▪ Accrual basis
▪ Income
▪ Cash flows ▪ Consistency
▪ Expenses
▪ Materiality

Presentation Requirements ▪ Minimum information on face

▪ Aggregation where appropriate ▪ Minimum disclosure
▪ No offsetting ▪ Comparative information
▪ Classified balance sheet ▪ Frequency of reporting

Qualitative Characteristics Enhancing Constraints

1. Relevance: Economic decisions, forecasts Characteristics ▪ Enhancing characteristics: No priority, trade-offs
of future events, evaluation of past events 1. Comparability ▪ Benefits > cost
2. Faithful representation: Complete, neutral, 2. Verifiability ▪ Excludes nonquantifiable information
free from error 3. Timeliness
4. Understandability
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 Financial Reporting Standards
Recognition of Items in Financial Statements
▪ Probable flows of benefit (to/from the firm)
Both required
▪ Measured with reliability

Assets Income
▪ Resources controlled by the entity resulting from past transactions Increases in economic benefits:
▪ Probable future economic benefit flow to enterprise ▪ Enhancement of assets
Liabilities ▪ Decrease of liabilities
▪ Obligations resulting from past events ▪ Revenue and gains
▪ Settlement results in probable resource outflow
Equity Expenses
▪ Shareholders’ residual interest Decreases in economic benefits:
▪ Assets – liabilities ▪ Outflows/depletion of assets
▪ Increases in liabilities
▪ Expenses and losses

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 Financial Reporting Standards

Complete questions: FR7-FR11

Time allocated: 6 minutes

6 4 2 1

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© Kaplan, Inc.
© CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.

FR7. Neutrality of information in the financial statements most closely

contributes to which qualitative characteristic?
A. Relevance.
B. Understandability.
C. Faithful representation.

© Kaplan, Inc. 16
 Financial Reporting Standards

FR8. The fundamental qualitative characteristics of financial

reporting set out in the IFRS Financial Reporting Standards
Framework least likely include:
A. relevance.
B. accrual basis.
C. faithful representation.

© Kaplan, Inc. 17
 Financial Reporting Standards

FR9. The presence of current and long-term liabilities and assets in

the balance sheet is a clear indication that which principle has been
applied?
A. Accruals.
B. Matching.
C. Going concern.

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 Financial Reporting Standards

FR10. An advantage of using historical cost accounting is:

A. it is objective and verifiable.
B. asset values are close to replacement cost.
C. inflation has little effect on the financial statements.

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 Financial Reporting Standards

FR11. Financial statements required under IFRS least likely include a

statement of:
A. comprehensive income.
B. changes in owners’ equity.
C. changes in pension liabilities.

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 Financial Statement Analysis Review

Financial Statement Analysis (2):

❑ Understanding Income Statements
❑ Understanding Balance Sheets
❑ Understanding Cash Flow Statements
❑ Financial Analysis Techniques

© Kaplan, Inc. 21
 Understanding Income Statements

X Gross sales less returns, allowances, and discounts = net sales

Sales
COGS (X)
Cost to manufacture or purchase the merchandise sold during the year
Gross margin X
Operating expenses (SG&A) (X)
For example, selling, general, and administrative expenses incurred
Operating income X (can be combined with COGS)
Other expenses (X)
Other revenues X
Unusual or infrequent items X/(X) For example, interest paid and rec’d, divs rec’d, rental income
Income before tax X (nonoperating)
Income taxes (X)
Income taxes incurred, income taxes payable + deferred tax
Net income from continuing X
operations
Discontinued operations X/(X) Separated from continuing operations, income, gains, and losses
Net income X net of tax presented here

Prior-year comparatives adjusted

for changes in accounting principle
© Kaplan, Inc. 22
 Understanding Income Statements

Process for Recognizing Revenue Contract

1. Identify contract(s) with a customer ▪ Agreement specifying rights and responsibilities
of two or more parties
2. Identify performance obligations in the contract ▪ Collectability must be probable
3. Determine transaction price
4. Allocate transaction price to performance obligations
Performance obligation
5. Recognize revenue when/as performance obligations Promise to deliver a distinct good or service and requires:
are satisfied ▪ Customer can benefit from good or service
▪ Promise to transfer good or service can be identified
separately from other promises
▪ Recognize revenue only when highly probable it will not
have to be reversed
▪ For long-term contracts, recognize revenue based on Transaction price
progress toward completion ▪ Amount firm expects to receive from customer
▪ When acting as agent, recognize only net amount ▪ May be fixed or variable
received as revenue

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 Understanding Income Statements
Accrual Basis, Matching Principle
▪ Match costs against the associated revenues
▪ Examples:
Costs that result in higher future earnings should be
▪ Inventory capitalized
▪ Capitalization
Costs that have uncertain impacts on future earnings
▪ Depreciation/Amortization
should be expensed
▪ Warranty expense
Costs that have no impact on future earnings should
▪ Doubtful debt expense
be expensed
Period Expenses
▪ Expenditures less directly matching the timings of revenues
(e.g., admin costs)

Analysis Implications
▪ Inventory valuation

Estimates and
Assumptions
▪ Warranty expense Review year-on-year consistency
▪ Depreciation Review footnotes and MD&A
▪ Amortization
▪ Doubtful debt provisions
▪ Revenue recognition
© Kaplan, Inc. 24
 Understanding Income Statements
Unusual or Infrequent Items Discontinued Operations
Reported pre-tax before net income from continuing Operations that management has decided to dispose of but:
operations (above the line): 1. Has not done so yet or
▪ Gain (loss) from disposal of a business segment or assets
2. Did so in current year after it generated profit or loss
▪ Gain (loss) from sale of investment in subsidiary
▪ Provisions for environmental remediation, impairments, Reported net of taxes after net income from continuing
write-offs, write-downs, restructuring operations (below the line)
▪ Integration expense for recently acquired business Must be physically and operationally distinct from firm

Types of Accounting Changes:

Change in accounting policy
Applied retrospectively unless impractical to do so, restate prior statements
Change in accounting estimate
Applied prospectively; disclosed in footnotes
Prior-period adjustment
Applied retrospectively; nature and effect on net income must be disclosed; may indicate weak internal controls

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 Understanding Income Statements

Basic EPS Diluted EPS

Net income – pref dividends
Weighted-average common shares Complex capital structure:
▪ Convertibles (debt/equity)
▪ Stock options/warrants
Net income – preferred dividends +
Weighted-Average Number of Shares Record EPS before and convertible preferred dividends +
after below-the-line items [convertible debt interest × (1 – t)]
Stock splits and stock dividends
retroactively applied for full year Weighted-average shares + shares from
conversions + net shares issuable from
Others from date of issue/repurchase
stock options

Stock options: Use treasury stock method:

Each Dilutive Security Must be Viewed in Isolation 1. Calculate cash raised on exercise
If result is greater than basic EPS, it is “antidilutive” and 2. Repurchase shares at average price
should be ignored 3. New shares = exercised – repurchased

Antidilutive if average price < exercise price

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 Understanding Income Statements
Comprehensive Income = Change in equity from transactions from non-ownership sources

Net Income X
∆ Foreign Currency Translation Adjustment X/(X)
∆ Pension adjustment to funded status X/(X)
∆ Unrealized gains or losses on derivatives contracts accounted for as X/(X)
hedges
∆ Unrealized gains and losses on available-for-sale securities X/(X)
Comprehensive Income X

Operating vs. Non-Operating Income

Financial Service Non-Financial
Companies Service Companies

Interest
Dividends
Gains/losses on disposal

Operating Non-operating
activities income
© Kaplan, Inc. 27
 Understanding Income Statements

Complete questions: FR12 –FR17

Time allocated: 7.5 minutes

7.5 5 2.5 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

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© Kaplan, Inc.
 Understanding Income Statements
FR12. Kus, Inc. is engaged in a long-term construction project with an initial cost
estimate of $1,000,000 and a contract price of $1,500,000. During the first year,
the firm incurred costs of $250,000. During the second year, the initial estimate of
total cost was revised to $1,100,000, and $350,000 of costs were incurred.
Revenues reported for the second year are closest to:
A. $445,000.
B. $475,000.
C. $525,000.
Year 1 revenue:
($250,000 / $1,000,000) × $1,500,000 = $375,000
Year 2 revenue:
[($250,000 + $350,000) / $1,100,000] × $1,500,000 – $375,000
= $443,182

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 Understanding Income Statements
FR13. Hopeful, Inc. had net income of $15,600,000 in the most recent year and a
weighted average of 6,000,000 common shares outstanding during the year.
Hopeful also had 24,000 convertible bonds outstanding with a par value of $1,000
and a coupon rate of 5%. Each bond is convertible into 10 common shares.
Hopeful’s tax rate is 40%. Diluted earnings per share for the year are closest to:
A. $2.58.
B. $2.60.
C. $2.62.
Basic EPS = $15,600,000 / 6,000,000 = $2.60
Test convertible bonds for dilution:
( $1,000 × 0.05 × 24,000 )(1 – 0.40 ) = $3.00 > basic EPS → antidilutive
24,000 × 10
→ diluted EPS = basic EPS

© Kaplan, Inc. 30
 Understanding Income Statements
FR14. For a non-financial company, interest and dividends received,
and gains and losses on the disposal of investments should most likely
be reported as:
A. income from operating activities.
B. non-operating income.
C. unusual or infrequent items.

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 Understanding Income Statements
FR15. Brashmount, Inc. had net income of $1.6 million for the year. Brashmount
had 140,000 common shares outstanding at the start of the year. On February 15,
the firm declared a 10% stock dividend, and on March 31, the firm issued 20,000
shares for cash. How many common shares should be used in computing the
company’s basic EPS?
A. 140,000.
B. 154,000.
 9 
C. 169,000. (140,000 )(1.10 ) +   ( 20,000 ) = 169,000
 12 

© Kaplan, Inc. 32
 Understanding Income Statements
FR16. An analyst gathers the following information about a company with a year-
end of December 31:
• Net income for the year was $25.2 million.
• Preferred stock dividends of $4.8 million were paid for the year.
• Common stock dividends of $8.4 million were paid for the year.
• 24 million common shares were in issue at the start of the year.
• 7.2 million further common shares were issued on April 1.
The company’s basic earnings per share was closest to:
A. $0.41.
B. $0.65. Earnings available to common = $25.2 – $4.8 = $20.4 million
C. $0.69. 9
Weighted average shares = 24 + ( 7.2 ) = 29.4 million
12
$20.4 / 29.4 = $0.69
© Kaplan, Inc. 33
 Understanding Income Statements
FR17. MNO, Inc. had 120,000 common shares outstanding throughout the year.
It also had warrants outstanding for 20,000 shares, exercisable at $18 per share.
The average price of MNO’s stock over the year was $36 and the year-end price
was $60. How many shares should be used in calculating MNO’s diluted
earnings per share?
A. 120,000.
B. 130,000. Exercise price < average price → dilutive
C. 140,000. Cash from exercise = $18 × 20,000 = $360,000
$360,000 / $36 = 10,000 shares repurchased
20,000 – 10,000 = 10,000 new shares issued
120,000 + 10,000 = 130,000 shares

© Kaplan, Inc. 34
 Understanding Balance Sheets
Balance Sheet
Assets
▪ Classified = ordered
1. Probable inflow of economic benefit
▪ Assets from most to least liquid (U.S.)
2. Measure with reliability
▪ Liabilities in the order of when due (U.S.)
▪ Stockholders’ equity: Contributed then retained
Long Lived
Current Held for continuing use within
Converted into cash or used up within one year (or one operating cycle if longer) the business, not resale

▪ Cash and cash equivalents (e.g., U.S. T-Bills ≤ 90 days term)

▪ Short-term investments
– Held-to-maturity: At cost (likely to be long lived)
– Trading (fair value through profit and loss): At fair market value
– Available for sale: At fair market value
▪ Accounts receivable: At net realizable value (i.e., less bad and doubtful debts)
▪ Notes receivable: At net realizable value, a promissory note with a maturity date/interest rate
▪ Inventory: FIFO, average cost, or specific identification, LIFO (U.S. GAAP only);
overstated closing inventory → understated cost of sales → overstated income
▪ Prepaid expenses: At cost
▪ Deferred tax assets
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 Understanding Balance Sheets
Long Lived Assets
Held for continuing use within the business, not resale Securities
▪ Fair value through P&L (trading securities)
▪ Fair value through OCI (available-for-sale)
▪ Amortized cost (held-to-maturity)

Property, Plant, and Equipment

▪ Land, at cost
Other Items
▪ Plant and buildings, at historic cost less accumulated depreciation
▪ Investment property (IFRS)
▪ Equipment at historic cost less accumulated depreciation
@ cost or fair value
▪ Intangible assets (e.g., patents, copyrights trademarks at historic
▪ Held-for-sale assets
cost less accumulated amortization)
test for impairment
Depreciation Methods
▪ Natural resources
▪ Straight line
▪ Accelerated (e.g., double declining balance)
▪ Units of production Asset Disposal
$
Proceeds X
NBV (X)
Profit/(loss) X/(X)
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 Understanding Balance Sheets
IFRS U.S. GAAP

Measured at fair value through P&L Trading securities

▪ Debt acquired with intent to sell in near term ▪ Debt acquired with intent to sell in near term
▪ Equity securities (unless fair value through OCI is chosen at ▪ Equity securities
time of purchase) ▪ Derivatives
▪ Derivatives
▪ Any security, if this treatment is chosen at time of purchase

Measured at fair value through OCI Available-for-sale securities

▪ Debt acquired with intent to collect interest but sell before ▪ Debt acquired with intent to collect interest but
maturity sell before maturity
▪ Equity (only if this treatment is chosen at time of purchase)

Measured at amortized cost Held-to-maturity securities

▪ Debt acquired with intent to hold until maturity ▪ Debt acquired with intent to hold until maturity
▪ Loans and notes receivable ▪ Loans/notes receivable and unlisted equity
▪ Unlisted equity securities, if fair value cannot be reliably securities are measured at historical cost
determined

© Kaplan, Inc. 37
 Understanding Balance Sheets
Balance Sheet LIABILITIES
▪ Classified = ordered
▪ Assets from most to least liquid
Current Long-term
▪ Liabilities in the order of when due
▪ Accounts payable, to ▪ Paid after more than one year
▪ Stockholders’ equity: Contributed then retained suppliers ▪ Notes and bonds: At present
▪ Other payables (e.g., wages, value of future cash payments
rent, taxes) ▪ Capital leases
▪ Accruals ▪ Provisions
▪ Notes payable: Promissory ▪ Deferred tax
notes with interest
STOCKHOLDERS’ EQUITY ▪ Provisions
▪ Deferred revenue (unearned)
▪ Dividends payable
▪ Contributed capital = common stock at par plus Accruals Process B/S
additional paid-in capital ▪ Current portion of long-term
▪ Accounts receivable
debt/capital leases
▪ Treasury stock ▪ Accrued revenue
▪ Deferred tax
▪ Retained earnings = accumulated net income ▪ Deferred revenue
less dividends ▪ Accrued expenses
▪ Comprehensive income items
▪ Accounts payable
▪ Minority (non-controlling) interests
▪ Prepaid expenses

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 Understanding Balance Sheets

Complete questions: FR18-FR23

Time allocated: 7.5 minutes

7.5 5 2.5 1

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© Kaplan, Inc.
 Understanding Balance Sheets
FR18. An increase in shareholders’ equity would most likely result from:
A. an increase in outstanding shares.
B. the repurchase of a firm’s stock at less than book value.
C. the conversion of convertible preferred shares to common stock.

© Kaplan, Inc. 40
 Understanding Balance Sheets
FR19. For investments classified as held to maturity under U.S. GAAP,
which of the following statements is least accurate?
A. They are held in the balance sheet at amortized cost.
B. Realized gains and losses are taken to the income statement.
C. Unrealized gains and losses are taken directly to equity.
not recognized on the balance sheet.

© Kaplan, Inc. 41
 Understanding Balance Sheets
FR20. Under U.S. GAAP, how are unrealized gains and losses on
available-for-sale securities reflected in owners’ equity?
A. Within retained earnings.
B. Other comprehensive income.
C. Adjustment to contributed capital.

© Kaplan, Inc. 42
 Understanding Balance Sheets
FR21. Which of the following investments is least likely to be valued at
cost or amortized cost on the balance sheet?
A. Unlisted instruments.
B. Bonds purchased with the intent to hold until maturity.
C. Non-derivative investments hedged by derivatives.
Shown at fair market value

© Kaplan, Inc. 43
 Understanding Balance Sheets
FR22. Which of the following statements regarding treasury stock is
most accurate?
A. Treasury stock is shares that have been reacquired by the
firm but not retired.
B. Acquiring treasury stock using the firm’s cash leaves owners’
equity unchanged.
C. In proxy votes, the firm’s management decides how to vote shares
held as treasury stock.

© Kaplan, Inc. 44
 Understanding Balance Sheets
FR23. Noncontrolling interest on the balance sheet is best described
as the:
A. parent company’s share of net assets held in a subsidiary.
B. minority shareholders’ pro-rata share of net assets of a
subsidiary not wholly owned by the parent.
C. minority shareholders’ pro-rata share of earnings for a subsidiary
not wholly owned by the parent.

© Kaplan, Inc. 45
 Understanding Cash Flow Statements
Relevance: Assess liquidity, solvency, and financial flexibility

Cash Flow from Operations X Cash Flow From Operations $

Cash received from customers X
Cash Flow from Investing X Cash dividends received X
Cash interest received X
Cash Flow from Financing X Other cash income X
Payments to suppliers (X)
Sum = Changes in cash X Cash expenses (wages etc) (X)
Cash interest paid (X)
Add: Cash at start of period X Cash taxes paid (X)
CFO X/(X)
Cash at end of period X

Free Cash Flow

CFO = net income + non-cash charges – working capital investment
FCFF = CFO + Int(1 – t) – fixed capital investment
FCFE = CFO – fixed capital investment + net debt increase
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 Understanding Cash Flow Statements
IFRS
Interest Rec’d CFO/CFI Cash Flow From Operations
Divs Rec’d CFO/CFI ▪ Includes cash flow from interest received and paid, and dividends received
Interest Paid CFO/CFF
▪ Includes all income taxes paid
Divs Paid CFF/CFO
Overdraft cash, not CFF

Direct Method Increases in an asset: deduct Indirect Method

Cash collections less cash paid for inputs Increase in a liability: add ▪ Start with income after taxes
less other cash outflows Decrease in an asset: add ▪ Adjust for non-cash and non-CFO items
Decrease in a liability: deduct

Cash Flow From Investing Cash Flow From Financing

▪ Cash spent on long-term assets ▪ Cash raised from equity and debt
▪ Proceeds from the sale of long-term assets ▪ Cash spent on repurchasing equity or redeeming debt
▪ Cash flows from investments in joint ventures, affiliates, and ▪ Dividends paid
long-term investments in securities (trading securities are CFO)

© Kaplan, Inc. 47
 Understanding Cash Flow Statements

Direct Method Steps:

1. Start at the top of the Income Statement (e.g., sales)
2. Move to the balance sheet and identify any asset and liability that relate to that Income Statement item (e.g., accounts
receivable)
3. Remember COGS has two adjustments: inventory and accounts payable
4. Look at the change in the Balance Sheet item during the period (ending balance – opening balance)
5. Apply the rule: ↑ Asset: deduct
↑ Liability: add
6. Adjust the Income Statement amount by the change in the Balance Sheet
7. Tick off the items dealt with in both the Income Statement and Balance Sheet
8. Move to the next item on the Income Statement and repeat
9. Ignore depreciation/amortization, gains and losses on the early retirement of debt and gains/losses on the disposal of
assets as these are all non-cash items
10. Adjust tax expense for deferred taxes and tax payable
11. Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1–8
12. Total up the amounts, and you have CFO

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 Understanding Cash Flow Statements
Indirect Method Steps:
1. Start at the bottom of the Income Statement (e.g., Net Income—this means we have already included all the items on the
Income Statement)
2. Return to the top of the Income Statement and adjust each item line by line. Note that we have already included Sales in
our Net Income figure
3. Look at the change in the Balance Sheet item during the period (ending balance – opening balance). These are identical
to the Direct Method!
4. Apply the rule: ↑ Asset: deduct
↑ Liability: add
5. Tick off the items dealt with in both the Income Statement and Balance Sheet
6. Move to the next item on the Income Statement and repeat
7. Eliminate depreciation and amortization by adding them back (they’ve been deducted in arriving at Net Income but have
no cash implication)
8. Eliminate gains on disposal and provisions by deducting them, and losses on disposal by adding them back
9. Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1–8
10. Total up the amounts, and you have CFO

© Kaplan, Inc. 49
 Understanding Cash Flow Statements
CFI = Cash additions – cash received on disposal CFI
Purchase of PP&E
$ $ Sales proceeds
Opening NBV X Proceeds * X Investment in JVs and affiliates
Additions X NBV (X) Purchase and proceeds from intangibles
Depreciation charge (X) Profit/(loss) X/(X) Purchase and sale of marketable securities
NBV of disposal * (X) (available-for-sale and held-to-maturity)
Closing NBV X * = computed plug figure

CFF
CFF
▪ Change in debt
Dividend payments ▪ Change in common stock
Issue/redemption of: ▪ Cash dividends paid
▪ Common stock
▪ Preferred stock Calculate dividends declared: Dividends declared (X)
▪ Treasury stock Net income X Δ dividends payable X/(X)
▪ Debt Dividends declared * (X) Cash dividends paid (X)
© Kaplan, Inc.
Δ in Retained Earnings X
50
 Understanding Cash Flow Statements

Complete questions: FR24-FR29

Time allocated: 7.5 minutes

7.5 5 2.5 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

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© Kaplan, Inc.
© CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.

FR24. Jaderong Plinkett Stores reported net income of $25 million. The company
has no outstanding debt. Using the following information from the comparative
balance sheets (in millions), what should the company report in the financing
section of the statement of cash flows in 2018?
Balance Sheet Item 12/31/2017 12/31/2018 Change
Common stock $100 $102 $2
Issuance
Additional paid-in capital common stock $100 $140 $40
Retained earnings $100 $115 $15
Total stockholders’ equity $300 $357 $57

A. Issuance of common stock of $42 million; dividends paid of $10 million.

B. Issuance of common stock of $38 million; dividends paid of $10 million.
C. Issuance of common stock of $42 million; dividends paid of $40 million.
$25 million net income – $15 million increase in retained earnings = $10 million dividends
© Kaplan, Inc. 52
© CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.

FR25. Based on the following information for Star Inc., what are the total net
adjustments that the company would make to net income in order to derive
operating cash flow? +$2 million depreciation
Year Ended +$3 million decrease in receivables
Income Statement Item 12/31/2018 –$4 million increase in inventories
+$5 million increase in payables
Net Income $20 million
+$6 million
Depreciation $2 million
Balance Sheet Item 12/31/2017 12/31/2018 Change
Accounts receivable $25 million $22 million ($3 million)
Inventory $10 million $14 million $4 million
Accounts payable $8 million $13 million $5 million

A. Add $2 million.
B. Add $6 million.
C. Subtract $6 million.
© Kaplan, Inc. 53
 Understanding Cash Flow Statements
FR26. Footnotes to a firm’s financial statements disclose that new equipment was
purchased for $360,000 in cash during 20X5. The footnotes also disclose the
following data (in thousands of dollars):
20X5 20X4
Gross PP&E 2,080 1,800
Accumulated depreciation 810 600
Carrying value 1,270 1,200
If depreciation expense for 20X5 was $240,000, what was the carrying value
of the PP&E disposed of during 20X5?
A. $30,000. Increase in gross PP&E = 2,080 – 1,800 = 280
B. $50,000. Gross value of equipment sold = 360 – 280 = 80
C. $80,000.
Increase in depreciation = 810 – 600 = 210
Depreciation of equipment sold = 240 – 210 = 30
Carrying value of equipment sold = 80 – 30 = 50
© Kaplan, Inc. 54
 Understanding Cash Flow Statements
FR27. Free cash flow to equity holders is equal to:
A. CFO + interest × (1 − tax rate) − fixed capital investment.
B. Net income + noncash charges − working capital investment +
fixed capital investment − net increase in debt.
C. Net income + noncash charges − working capital investment
− fixed capital investment + net increase in debt.

© Kaplan, Inc. 55
 Understanding Cash Flow Statements
FR28. Payments for investments in joint ventures or affiliates are
classified as cash flows from:
A. operations.
B. investing.
C. financing.

© Kaplan, Inc. 56
 Understanding Cash Flow Statements
FR29. The acquisition of a machine with financing provided by the
seller affects which area of the cash flow statement at the time of
purchase?
A. Cash flows from investing.
B. Cash flows from financing.
C. No impact on cash flow statement.

© Kaplan, Inc. 57
 Financial Analysis Techniques
Liquidity
Cash conversion cycle = Receivables turnover
Current ratio = CA/CL
= Revenue
Quick/Acid test Days of sales outstanding
Average AR
= Cash + Marketable Sec + AR
+ Days of inventory on hand Days of sales outstanding
CL
Cash ratio – Number of days of payables = 365
= Cash + Marketable Sec AR T/O
CL
Defensive interval
Inventory turnover
= Cash + Marketable Sec + AR
=
Daily Cash Expenditure COGS
Average Inv
Payables turnover Number of days of payables
= Purchases 365 Days of inventory on hand
=
Average AP = 365
AP T/O
Inv T/O
© Kaplan, Inc. 58
 Financial Analysis Techniques
Return on Sales Return on Investment Return on Investment

Gross Profit Margin Return on Assets ROA Return on Total Capital

Rev – COGS (GP) Net Income EBIT
Revenue Avg. Total Assets Avg. Total Capital
Operating Profit Margin Return on Assets ROA Return on Equity
EBIT (Operating Income) NI + Int (1 – T) NI
Revenue Avg. Total Assets Avg. Equity
Net Profit Margin Operating ROA Return on Common Equity
NI Operating Income NI – Pref Div
Revenue Avg. Common Equity
Avg. Total Assets

Vertical Common Size Statements

Income statement Balance sheet
Income Statement Account Balance Sheet Account
Sales Total Assets
Horizontal Common Size Statements
Each line relative to base year
© Kaplan, Inc. 59
 Financial Analysis Techniques

ROE = NI

Equity

ROE = NI Revenue
×
Revenue Equity

ROE = NI Revenue Assets

× ×
Revenue Assets Equity
Total Asset T/O Financial Leverage
Multiplier

ROE = EBIT EBT NI Revenue Assets

× × × ×
Revenue EBIT EBT Assets Equity
Interest Burden Tax Burden

© Kaplan, Inc. 60
 Financial Analysis Techniques
Operating Risk Financial Risk
Long-term liabilities
Coefficient of Variation of Debt-to-Assets (total debt)
Interest bearing short-term liabilities
Operating Income
Deferred tax Total Debt
σ EBIT
μ EBIT PV of operating leases Total Assets
Redeemable pref Debt-to-Capital
Coefficient of Variation of
Revenue Total Debt

σ Revenue Total Debt + Stockholders Equity

μ Revenue
Debt-to-Equity
Common stock
Operating Leverage Irredeemable preferred stock Total Debt
% Δ in EBIT Stockholders Equity
Additional paid-in capital
% Δ in Sales
Comprehensive income items Financial Leverage
Retained earnings
Average Total Assets
Average Total Equity

© Kaplan, Inc. 61
 Financial Analysis Techniques
Solvency
Interest Coverage Activity Ratios
EBIT Working Capital
= CA – CL
Interest Expense
Working Capital Turnover
Revenue
Fixed Charge Coverage
Average Working Capital
EBIT + Lease Payments
Fixed Asset Turnover
Interest Expense + Lease Payments Revenue
Average Net Fixed Assets

Sustainable Growth

g =(Earnings Retention Rate)(ROE)

[1 – (Payout Ratio)]

Common Dividend
Net Income – Pref Div

© Kaplan, Inc. 62
 Financial Analysis Techniques
Performance Coverage Coverage
Cash Flow to Revenue Debt Coverage Dividend Payment
CFO CFO CFO
Net Revenue Dividends Paid
Total Debt
Cash Return on Assets Investing and Financing
Interest Coverage
CFO
CFO + Interest + Tax CFO
Avg. Total Assets
Interest Paid Cash Outflows for CFI & CFF
Cash Return on Equity
CFO Reinvestment
Avg. Equity CFO
Common Size Statements
Cash to Income Cash Paid for Long-term
Assets 1. Show each item as a % of Net Revenue or
CFO 2. Show each inflow as a % of total inflows
Operating Income Debt Payment Show each outflow as a % of total outflows
Cash Flow Per Share CFO

CFO – Pref Div Cash Paid for Long-term

Debt Repayment
No Common Stock

© Kaplan, Inc. 63
 Financial Analysis Techniques
Reportable Segment
▪ 50% of its revenue earned externally Segment Margin
▪ If a business area has at least 10% of a firm’s:
Segment Profit
▪ Revenue; OR
▪ Operating profit; OR Segment Revenue
▪ Use of assets
▪ Business type and geographical segments Segment Asset Turnover
Segment Revenue
Disclosure for Each Segment Segment Assets
▪ Revenue (external and internal)
▪ Segment result (operating profit) Segment ROA
▪ Carrying amount of segment assets Segment Profit
▪ Segment liabilities (IFRS)
▪ Cost of PP&E and intangibles acquired Segment Assets
▪ Depreciation and amortization expense
▪ Other non-cash expenses Segment Debt Ratio
▪ Share of profit/loss from equity accounted investments
Segment Liabilities
▪ Reconciliation between segment data and consolidated statements
Segment Assets

© Kaplan, Inc. 64
 Financial Analysis Techniques
Credit Rating Process
1. Meet chief financial officer Funds from operations to total debt
▪ Strategy NI adj for non-cash items
▪ Industry overview Total Debt
▪ Accounting policies
2. Tour major facilities Free operating cash flow to total debt
3. Vote on analyst recommendations CFO – Capex
▪ Business risk Total Debt
▪ Financial risk
Total Debt to EBITDA
4. Monitor publicly distributed ratings
Total Debt
EBITDA
EBIT Interest Coverage Return on capital
EBIT Incl’ capitalized EBIT
Gross Interest interest Capital

EBITDA Total debt to total debt + equity

EBITDA Total Debt
Gross Interest Total Debt + Equity
© Kaplan, Inc. 65
 Financial Analysis Techniques

Complete questions: FR30-FR35

Time allocated: 7.5 minutes

7.5 5 2.5 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

66666666 66
© Kaplan, Inc.
 Financial Analysis Techniques
FR30. TG Industries reports a current ratio of 0.8 and a quick ratio of
0.6. A creditor has agreed to accept inventory with a cost of $50,000 to
settle an accounts payable balance of $50,000. TG’s current assets are
$290,000. What effects will this transaction have on TG’s current ratio
and quick ratio?
Current ratio Quick ratio
Current ratio:
A. Increase Decrease CA ↓50, ↓CL 50
B. Decrease Increase Because ratio < 1, equal decreases
C. Increase Increase in numerator and denominator will
decrease the ratio
Quick ratio:
(CA – Inv) no change, ↓CL 50

© Kaplan, Inc. 67
 Financial Analysis Techniques
FR31. Average
Euros (millions) 20X7 20X6 20X5
Short-term debt 198 175 181
Long-term Debt 279 302 298
Total Liabilities 549 541 533 518
Total Equity 354 369 384 379

Using the selected information for Mode de Printemps above, its financial leverage
ratio for 20X7 is closest to:
A. 1.35.
B. 2.47. = (541 + 369) / 369
C. 2.55.

© Kaplan, Inc. 68
 Financial Analysis Techniques
FR32. DB Products Inc. currently has a current ratio of 1.8. If DB pays
off some of its accounts payable using cash, what effects will this have
on its current ratio and number of days of payables?
Current ratio Days of payables
A. Increase Decrease
B. Decrease Increase
C. Decrease Decrease

Because current ratio > 1, equal decreases in numerator and denominator

will increase the ratio
Other things equal, decrease in payables → decrease in days’ payables

© Kaplan, Inc. 69
 Financial Analysis Techniques
FR33. If ABC, Inc. has accounts receivable of $22 million, sales of
$350 million, and cost of goods sold of $270 million, days of sales
outstanding are closest to:
A. 16 days.
365
B. 23 days. =
350
C. 30 days. 22

© Kaplan, Inc. 70
 Financial Analysis Techniques
FR34. If DEF, Inc. has a closing inventory of $18 million, sales of $350
million, and cost of goods sold of $270 million, days of inventory on
hand are closest to:
A. 19 days.
B. 20 days.
365
C. 24 days. =
270
18

© Kaplan, Inc. 71
 Financial Analysis Techniques
FR35. GHI, Inc. has accounts payable of $12 million, sales of $350
million, and cost of goods sold of $270 million. Beginning inventory was
$20 million and ending inventory is $50 million. GHI’s days of payables
are closest to:
A. 12 days.
B. 15 days. Purchases = EI – BI + COGS
C. 16 days. = 50 – 20 + 270 = $300 million
365
= 14.6
300
12

© Kaplan, Inc. 72
 Financial Statement Analysis Review

Financial Statement Analysis (3):

❑ Inventories
❑ Long-Lived Assets
❑ Income Taxes
❑ Non-Current (Long-Term) Liabilities

© Kaplan, Inc. 73
 Inventories
Inventory cost methods:
Beginning Inventory (BI) X
+ Purchases (P) X Matching ▪ Specific ID: High value items
Available for Sale concept ▪ FIFO: EI = Newest purchases
X
▪ LIFO: EI = Oldest purchases
– Ending Inventory (EI) (X)
▪ Average cost: EI = Available for Sale
Cost of Goods Sold (COGS) X
Units

Assuming rising prices LIFO FIFO Inventory Systems

Income Statement COGS HIGHER LOWER Periodic

EBT LOWER HIGHER ▪ Inventory and COGS determined at end of period
TAXES LOWER HIGHER Perpetual
NI LOWER HIGHER ▪ Inventory and COGS updated for each sale
▪ No purchases account needed
Impact on cost flow methods:
Balance Sheet INV LOWER HIGHER ▪ FIFO = same
W/C LOWER HIGHER ▪ LIFO = different
R/E LOWER HIGHER ▪ Average cost = different
▪ FIFO & LIFO relationships remain
Cash Flows CFO HIGHER LOWER

© Kaplan, Inc. 74
 Inventories
Inventory Valuation
Lower of cost or net realizable value: IFRS and U.S. GAAP except:
Lower of cost or market value: U.S. GAAP if LIFO or retail method is used

Cost NRV $ Inventory Management

Normal cost of getting inventory into Estimated selling price X Low T/O (high DOH):
current condition and location Slow-moving or obsolete inventory
Estimated cost of completion (X)
Excludes:
Selling costs (X)
Abnormal costs High T/O (low DOH), sales growth
NRV X below industry average:
Storage costs
Market Value Lost sales from stock outs
Selling costs (U.S. GAAP: LIFO, retail method)
Admin overheads Replacement cost subject to: High T/O (low DOH), sales growth
▪ Upper limit = NRV above industry average:
IFRS: Subsequent reversal allowed
▪ Lower limit = NRV – Efficient inventory management
U.S. GAAP: Subsequent reversal prohibited normal profit margin

Methods that report inventory above cost are rare. Permitted for commodity
producers/dealers (B/S = NRV, unrealized gains/losses to I/S).
© Kaplan, Inc. 75
 Inventories
LIFO Reserve LIFO Liquidation Inventory Analysis
LIFO inventory (w/increasing cost) Use:
+ LIFO reserve # inventory units drawn down • Disclosures
FIFO Inventory COGS reduced by using older, lower costs • MD&A
Unsustainable increase in gross profit, net income • Industry info
LIFO COGS
– change in LIFO reserve
Increase in raw materials and work-in-
FIFO COGS process may indicate expected increase
Inventory Disclosures in demand.
LIFO retained earnings • Cost flow method
+ LIFO reserve(1 – t) Increasing finished goods w/decreases in
• Inventory by category: Raw materials, work-in-
FIFO retained earnings raw materials and work-in-process may
process, finished goods
indicate expected decrease in demand.
LIFO cash • Inventory carried at fair value – selling expense
– LIFO reserve(t) • COGS for period Finished goods growing faster than sales
may indicate declining demand,
FIFO cash • Write-downs for period
excessive or obsolete inventory.
• Reversals of write-downs with explanation
• Value pledged as collateral

© Kaplan, Inc. 76
 Inventories

Complete questions: FR36 – FR41

Time allocated: 7.5 minutes

7.5 5 2.5 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

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© Kaplan, Inc.
© CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.

FR36. Like many technology companies, TechnoTools operates in an

environment of declining prices. Its reported profits will tend to be
highest if it accounts for inventory using the:
A. FIFO method.
B. LIFO method.
C. weighted average cost method.

© Kaplan, Inc. 78
 Inventories
FR37. RTZ, Inc. had beginning inventory of $134,000, purchased
$956,000 of goods during the year, and cost of goods sold was
$879,000. What is RTZ’s ending inventory?
A. $57,000.
B. $134,000.
C. $211,000. = $134,000 + $956,000 – $879,000

© Kaplan, Inc. 79
 Inventories
FR38. Zeta Company uses the LIFO inventory cost method and
Omega Company uses the FIFO method. Assuming the two firms are
identical in all other respects and that production costs have been
rising, Zeta Company will most likely report higher:
A. liabilities.
B. cost of sales.
C. ending inventory.

© Kaplan, Inc. 80
 Inventories
FR39. Reversing an inventory writedown will most likely increase:
A. cash flow.
No effect
B. the quick ratio.
C. the current ratio.

© Kaplan, Inc. 81
 Inventories
FR40. Which of the following statements is least accurate concerning
the effects of periodic and perpetual inventory systems?
A. No purchases account is required for a perpetual system.
B. Cost of goods sold is unaffected by the choice between
periodic and perpetual inventory systems for firms that use
the FIFO or average cost inventory methods.
C. Cost of goods sold are determined continuously, at the time of
each sale, under a perpetual inventory system.

© Kaplan, Inc. 82
 Inventories
FR41. Vish, Inc., uses the LIFO method and pays tax at 30%. For the
year, Vish showed a net profit of $200,000 and a LIFO reserve that
increased by $2,000 to a year-end level of $10,000. Net profit under
the FIFO method would have been closest to:
A. $201,400. = $200,000 + (1 – 30%) × $2,000
B. $202,000.
C. $207,000.

© Kaplan, Inc. 83
 Long-Lived Assets
Assets held for continuing usage in the business, not resale, should be capitalized

Capitalize costs that result in higher future earnings ▪ Invoice price

Expense costs that have uncertain impacts on future earnings ▪ Sales tax
▪ Freight and insurance
Expense costs that have no impact of future earnings ▪ Installation costs

CAPITALIZE EXPENSE Interest

Income variability LOWER HIGHER Capitalized during the construction period when
Profitability, early years HIGHER LOWER a firm constructs its own operating facilities

Profitability, later years LOWER HIGHER The interest must actually be paid by the firm
Specific and general debt interest capitalized
Total cash flows SAME SAME
CFO HIGHER LOWER
CFI LOWER HIGHER

Debt/equity ratio LOWER HIGHER

© Kaplan, Inc. 84
 Long-Lived Assets
X Accounting depreciation: spreading of cost over life
Historic Cost
(X) Economic depreciation: decline in value
Accumulated Depreciation
X Accounting depreciation ≠ Economic depreciation
NBV (carrying value B/S)

▪ Straight-line depreciation Cost – residual value

Useful life
▪ Accelerated depreciation
▪ Double declining balance
(Cost – Accum Depn) × 2 / useful life
▪ Units-of-production/service hours
▪ Depletion
Units prod/Hours worked
▪ Amortization Depn = (Cost – RV) ×
Total units/hours

Changes to useful life, residual value: ↑ life or ↑ salvage = ↓ future depreciation

Accounting estimate
↓ life or ↓ salvage = ↑ future depreciation
Changes to method: Accounting principle,
cumulative effect on prior periods
Component Depreciation
Required by IFRS, permitted by U.S. GAAP
© Kaplan, Inc. 85
 Long-Lived Assets
Capitalizing Intangibles

Not capitalized under U.S. GAAP: Capitalized under U.S. GAAP: $

–R&D – Purchased patents, copyrights, franchises,
Proceeds X
– Advertising licenses, brands, and trademarks
– Software development to establish – Direct response advertising FMV net assets (X)
feasibility – Goodwill arising from transactions acquired
– Software development costs once feasibility is
Goodwill X
established

IFRS requires ▪ The process is clearly defined Identifiable intangibles: Can be separated from firm
expensing of
research cost but ▪ Cost can be clearly identified Unidentifiable intangibles: Cannot be separated from firm
allows the ▪ Technical feasibility established Finite lived: Amortize
capitalization of
development ▪ Firm intends to produce the product Indefinite lived: Annual impairment review
costs when the ▪ The market has been clearly defined
following criteria
are met: ▪ The firm has resources to complete

© Kaplan, Inc. 86
 Long-Lived Assets
Asset Derecognition Tangible/Intangible Asset Disclosures
Proceeds X ▪ Carrying value for each class
NBV (X) ▪ Accumulated depreciation, amortization for each class
▪ Title restrictions, assets used as collateral
Profit/(loss) X/(X)
▪ Impairments: Loss amount, circumstances
▪ Revalued assets (IFRS): Revaluation date, determination of fair value,
▪ Abandoned: Proceeds = 0 carrying value using historical cost model
▪ Exchanged: Proceeds = fair value
▪ Classified held-for-sale and tested for impairment
once selling process commences
Asset Revaluation (IFRS)
▪ Held at lower of cost or fair value less selling costs
IFRS allows firms to report PP&E at fair market value
▪ Disclosure in MD&A, footnotes on revaluation dates (depreciation taken between
revaluation dates)

Upward Revaluation:
▪ B/S asset increased to fair market value Downward Revaluation:
▪ First, reverse any previously recognized ▪ B/S asset decreased to fair market value
revaluation losses related to the asset ▪ First, reduce any revaluation surplus related to the asset
▪ Then, recognize any additional increase in value in ▪ Then, recognize loss for any additional decrease in value
revaluation surplus (part of equity)

© Kaplan, Inc. 87
 Long-Lived Assets
Two-step Process for Recognizing Impairment (U.S. GAAP)
1. Recoverability test: Carrying value is greater than the undiscounted cash flow from the asset’s use and disposal
2. Loss measurement: Loss is the excess of carrying value over the asset’s fair market value or present value of cash flows
One-step Process for Recognizing Impairment (IFRS)
Compare carrying value to:
i. Fair value – selling costs
ii. Value in use

↓Fixed Assets ↓Current NI

Impairment Recovery
↓Def Tax ↓Future Depn
↓Equity ↑ Future ROE & ROA Held-for-use:

Disclosure: MD&A, footnotes IFRS: Subsequent reversal allowed

U.S. GAAP: Subsequent reversal prohibited
Investment Property (IFRS only) Held-for-sale:
▪ Owned for rental income or capital appreciation No longer depreciated
▪ Cost model or fair value model
Impaired if book value > (fair value – selling costs)
▪ If fair value model, gains or losses relative to cost recognized
on income statement (as with trading securities) Loss reversal allowed under IFRS & U.S. GAAP

© Kaplan, Inc. 88
 Long-Lived Assets

Complete questions: FR42-FR47

Time allocated: 7.5 minutes

7.5 5 2.5 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

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 Long-Lived Assets
FR42. A firm decides to begin capitalizing software development costs
that had previously been expensed because management believes
technological feasibility has been established. Compared to expensing
these costs, capitalizing them will most likely result in debt-to-equity
and asset turnover ratios that are:
Debt-to-equity Asset turnover
A. lower lower
B. lower higher
C. higher lower

Increases assets, no effect on debt → increases equity, decreases D/E

Increases assets, no effect on revenues → decreases turnover
© Kaplan, Inc. 90
© CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.

FR43. An analyst is studying the impairment of the manufacturing equipment of

WLP Corp., a UK-based corporation that follows IFRS. He gathers the following
information about the equipment:
Fair value £16,800,000
Costs to sell £800,000
Value in use £14,500,000
Net carrying amount £19,100,000
The amount of the impairment loss on WLP Corp.’s income statement related to its
manufacturing equipment is closest to:
A. £2,300,000.
B. £3,100,000. Write down to greater of value in use or recoverable amount
C. £4,600,000. Recoverable amount = £16,800,000 – £800,000 = £16,000,000
Impairment = £19,100,000 – £16,000,000 = £3,100,000

© Kaplan, Inc. 91
 Long-Lived Assets
FR44. Impairment of a long-lived asset is least likely to affect a firm’s:
A. net income.
B. debt-to-equity ratio.
C. cash flow from operations.

Non-cash charge, no tax effects

© Kaplan, Inc. 92
 Long-Lived Assets
FR45. A firm buys a machine for $40,000 that has an estimated useful
life of four years and an estimated salvage value of $4,000. What is
the first year’s depreciation using the double-declining balance
method?
A. $5,000.
B. $10,000.
C. $20,000. = 2 × ($40,000 / 4)

© Kaplan, Inc. 93
 Long-Lived Assets
FR46. A firm buys a machine for $40,000. The machine is expected to
produce 24,000 units of output over its estimated useful life of four
years, after which the firm expects to sell the machine for $4,000. The
firm will depreciate the machine using the units of production method.
If output in the first year is 8,000 units, depreciation for the year is:
A. $9,000.
B. $12,000. 8,000 / 24,000 = 33% of units
C. $20,000.
33% × ($40,000 – $4,000) = $12,000

© Kaplan, Inc. 94
 Long-Lived Assets
FR47. Herstatt, Inc. recognizes an impairment loss on its long-lived
assets. What are the most likely impacts on Herstatt’s return on equity
in the period of the impairment and in future periods?
Current ROE Future ROE
A. Increase Decrease
B. Increase Increase
C. Decrease Increase

Current period ROE decreases (assuming net income < equity)

Lower equity → higher future ROE

© Kaplan, Inc. 95
 Income Taxes
Tax Reporting
Deferred Tax Liability
Revenue X
Tax allowable costs (X) Tax > Accounting
Taxable income X Taxes payable Deduction Expense
Tax @ 30% (X)
Financial Accounting
Revenue X Income Taxes Payable Pay less tax
Accrual based costs (X) tax + now but more
=
Pre-tax income expense ∆ Deferred Tax
X on reversal
Tax @ 30% (X)

▪ Accrual vs. modified cash accounting

Sources of Differences ▪ Differences in reporting methods and Pay more tax
estimates now but less
▪ Timing differences on reversal
▪ Permanent differences
Income Tax Expense
Pretax Income Deferred Tax Asset

Statutory tax rate ≠ effective tax rate Accounting Tax

>
Expense Deduction
Tax expense ≠ Pre-tax income × statutory rate
© Kaplan, Inc. 96
 Income Taxes
Changes in Tax Rate Asset Tax Base

Tax base ≠ carrying

temporary timing
↑tax rate: Increase in deferred tax net Amounts deductible in future tax

value due to

differences
liability increases tax expense returns
Liability Tax Base
↓tax rate: Decrease in deferred tax net
liability reduces tax expense Carrying value less amounts that
will be deductible in future tax
Adjustment in the period when the tax returns (except deferred revenue)
rate changes (no restatement of prior
(Tax base – Carrying value) × t = DTA or (DTL)
periods)
Analyst Adjustments
Deferred Tax Assets: Issues ▪ Reversal expected: liability
▪ Nonreversal expected: equity
▪ Will only benefit on reversal if there are sufficient ▪ Reversal uncertain: ignore
taxable earnings ▪ Valuation allowance
▪ Can only utilize loss carryforwards if we have ▪ Present values
future profits
Sources of Common
If the asset cannot be utilized in full, it is reduced Permanent Differences:
by a contra “valuation allowance” (U.S. GAAP)
▪ Tax exempt expenses
▪ Reduces assets ▪ Reduces net income ▪ Tax credits on some expenditures
© Kaplan, Inc. 97
 Income Taxes
Sources of Common Timing Differences Required Disclosure
▪ Depreciation methods ▪ DTL, DTA, valuation allowance, and change in valuation allowance
▪ Undistributed earnings in subsidiaries, associates, and joint ventures
▪ Asset revaluations (IFRS only)
▪ Current year effect of each source of temporary difference
▪ Warranty provisions
▪ Components of income tax expense
▪ Impairments ▪ Tax loss carryforwards
▪ Restructuring provisions ▪ Reconciliation between statutory, effective tax rates
▪ Revenues received in advance
▪ Inventory accounting (not IFRS or U.S. GAAP)
Differences: IFRS vs. U.S. GAAP
▪ Pension expense
▪ IFRS revaluation of PP&E, intangibles
▪ Unrealized gains and losses on investments
▪ Undistributed earnings from subsidiaries, associates,
▪ Earnings from group companies (unless parent and joint ventures
controls timing of reversal or it is unlikely to reverse) ▪ DTA:
▪ Fair value adjustments on assets and liabilities ▪ IFRS: Only if “probable utilization”
acquired in a business combination ▪ U.S. GAAP: Full recognition less valuation
▪ NOT goodwill or goodwill impairments allowance
▪ Presentation:
▪ IFRS: Noncurrent
▪ U.S. GAAP: Current and noncurrent

© Kaplan, Inc. 98
 Income Taxes

Complete questions: FR48-FR53

Time allocated: 7.5 minutes

7.5 5 2.5 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

99999999 99
© Kaplan, Inc.
 Income Taxes
FR48. Selected data from Reuser, Inc.’s financial statements are as follows:
20X5 20X4
Pretax income 16.0 8.0
Income taxes payable 3.0 2.5
Change in deferred tax liability 1.0 (0.5)
Deferred tax liability at year-end 2.5 1.5

Reuser’s effective tax rate for 20X5 is closest to:

A. 15%.
B. 20%. Tax expense = 3.0 + 1.0 = 4.0
C. 25%.
Effective tax rate = 4.0 / 16.0 = 25%

© Kaplan, Inc. 100

 Income Taxes
FR49. Hewie, Inc. purchased equipment for $300,000. On its financial
statements, Hewie depreciates the equipment over six years using the
straight-line method with no residual value. For tax purposes, Hewie
uses double-declining balance depreciation over five years. What is the
tax base of the asset at the end of Year 1?
A. $120,000.
B. $180,000. = $300,000 – [2 × ($300,000 / 5)]
C. $250,000.

© Kaplan, Inc. 101

© CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.

FR50. Cinnamon, Inc. recorded a total deferred tax asset in Year 3 of

$12,301, offset by a $12,301 valuation allowance. Cinnamon most likely:
A. fully utilized the deferred tax asset in Year 3.
B. has an equal amount of deferred tax assets and deferred tax
liabilities.
C. expects not to earn any taxable income before the deferred tax
asset expires.

© Kaplan, Inc. 102

 Income Taxes
FR51. A difference between the effective tax rate and the statutory tax
rate is least likely to result from:
A. taxes on overseas earnings.
B. permanent timing differences.
C. temporary timing differences.

© Kaplan, Inc. 103

 Income Taxes
FR52. In the period when a deferred tax liability reverses, tax expense
on the income statement is:
A. equal to taxes payable on the tax return.
B. greater than taxes payable on the tax return.
C. less than taxes payable on the tax return.

© Kaplan, Inc. 104

 Income Taxes
FR53. Inka Corporation has deferred tax assets of $20 million and
deferred tax liabilities of $50 million. The corporate tax rate decreases
from 40% to 35%. What effect will the tax rate change have on net
income?
A. Increase net income.
B. Decrease net income.
C. No effect on net income.
Decrease in tax rate decreases value of both DTLs and DTAs
• Decrease in DTL increases net income (↓ income tax expense)
• Decrease in DTA decreases net income (↑ income tax expense)
With DTL > DTA, decrease in tax rate increases net income

© Kaplan, Inc. 105

 Non-Current (Long-Term) Liabilities
Discount Bond
N = Periods
Interest Expense = Coupon + Amortization
PV = Proceeds*
Premium Bond
CPT I/Y
PMT = Coupon Interest Expense = Coupon – Amortization
I/Y = effective rate Zero Coupon
FV = Redemption amount
* Proceeds – issuance costs (IFRS)
Interest Expense = Amortization

Analysis: Market value of debt more relevant than book value: Recent changes allow more liabilities
to be recorded at fair value (both IFRS and U.S. GAAP require disclosure of fair value)

Amortization of Premiums and

Gain/(loss) on Early Retirement
Discounts
Book value (B/S) X IFRS: Effective rate only
U.S. GAAP: Straight-line or effective rate
Cash paid (X)
Gain/(Loss) X/(X)
Issuance Costs
Unamortized issue costs (X) U.S. GAAP only Deduct from proceeds and liability,
↑ effective interest rate
Gain/(Loss) on repurchase X/(X) I/S continuing operations (Permitted under U.S. GAAP: Show as separate
prepaid asset and amortize)

© Kaplan, Inc. 106

 Non-Current (Long-Term) Liabilities
Covenants Disclosures
▪ Breach is technical default ▪ Nature of liability
▪ Affirmative: Borrower agrees to… ▪ Maturity dates
▪ Negative: Borrower will refrain from…
▪ Stated and effective interest rates
▪ Call and conversion features
Activity Based (Restrictions)
▪ Covenants
▪ Dividends and share repurchases
▪ Production and investment ▪ Security pledged as collateral
▪ Mergers and acquisitions ▪ Debt maturity in each of the next five years
▪ New debt issuance ▪ Fair value of outstanding instruments
▪ Payoff patterns and liquidation priority
▪ Maintenance of assets used as collateral MD&A
▪ Discussion
Accounting Based ▪ Qualitative and quantitative
▪ Adjustments to financial statements ▪ Trends, mix, cost
▪ Stockholders’ equity
▪ Off-balance-sheet finance
▪ Working capital (liquidity ratios)
▪ Interest coverage
▪ Debt/equity (solvency ratios)

© Kaplan, Inc. 107

 Non-Current (Long-Term) Liabilities
A lease is a contract that: Reasons to lease:
▪ Refers to a specific asset ▪ Cheaper financing
▪ Gives the lessee effectively all economic benefits of the asset ▪ Smaller initial cash outflow
during the term of the contract ▪ Reduced risk of obsolescence
▪ Gives the lessee the right to determine how to use the asset
during the term of the contract

Finance lease
▪ Transfers both the benefits and the risks of ownership to the lessee A lease will be classified
the same way by both
the lessee and the lessor
Operating lease
▪ Either benefits or risks do not substantially transfer to the lessee

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 Non-Current (Long-Term) Liabilities
Lessee Accounting (finance and operating under IFRS, finance leases under U.S. GAAP)
Recognize a right-of-use asset and a lease liability, both equal to the PV of future lease payments
▪ Depreciate right-of-use asset straight-line over the lease term
▪ Amortize liability over lease term using effective interest method
▪ Asset ≠ liability during lease term, but both reach zero at end of lease term
▪ Principal portion of lease payment is a CFF outflow
▪ Interest portion of lease payment is a CFO outflow (U.S. GAAP), CFO or CFF outflow (IFRS)

Lessee Accounting (operating leases under U.S. GAAP)

Same as finance leases, except:
▪ Depreciation of right-of-use asset each period equals amortization of lease liability
(therefore asset = liability during lease term)
▪ Asset depreciation and liability amortization are combined on income statement as lease expense
▪ Entire lease payment is a CFO outflow

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 Non-Current (Long-Term) Liabilities
Lessor Accounting: IFRS and U.S. GAAP
Finance lease:
▪ Remove leased asset from balance sheet, add lease receivable = PV of lease payments
▪ Recognize gain or loss if PV of lease payments ≠ book value of leased asset
▪ Amortize lease receivable using effective interest method
▪ Recognize interest portion of lease payments as income
▪ Entire lease payment is a CFO inflow
Operating lease:
▪ Keep leased asset on balance sheet
▪ Recognize depreciation expense on leased asset
▪ Recognize entire lease payment as income
▪ Entire lease payment is a CFO inflow

© Kaplan, Inc. 110

 Non-Current (Long-Term) Liabilities
Defined Benefit Plans Change in Net Pension Asset or Liability During Year
▪ Employer promises specific payment
▪ Service costs: PV of additional benefits earned
stream at retirement
▪ Contributions based on years of service, ▪ Past service costs: Retroactive benefits awarded when plan is
compensation at/near retirement initiated or changed
▪ Employer bears investment risk ▪ Net interest expense/income: Beginning value
▪ Separate legal entity manages plan assets × assumed discount rate
▪ Actuarial gains/losses: Changes in assumptions
▪ Return on plan assets

Defined Contribution Plans

▪ Employer contributes specified sum each period
▪ No guarantee of future benefits
▪ Employee bears investment risk
▪ Pension expense = employer contribution

© Kaplan, Inc. 111

 Non-Current (Long-Term) Liabilities

Complete questions: FR54-FR59

Time allocated: 7.5 minutes

7.5 5 2.5 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

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 Non-Current (Long-Term) Liabilities
FR54. The full lease payment is reported in the income statement of a
firm that reports:
A. a lease under IFRS.
B. a finance lease under U.S. GAAP.
C. an operating lease under U.S. GAAP.

© Kaplan, Inc. 113

 Non-Current (Long-Term) Liabilities
FR55. Murray, Inc. issues $1 million face value of four-year, annual-
pay bonds with a coupon of 8%. The market yield on these bonds
when issued is 10%. Interest expense in the first year of the bonds’ life
is closest to:
A. $80,000. Initial bond liability (= cash proceeds from issuance):
B. $95,000. N=4
C. $110,000. I/Y = 10
PMT = 0.08 × (–1,000,000) = –80,000
FV = –1,000,000
CPT PV = 936,603

Year 1 interest expense = 10% × $936,603 = $93,660

© Kaplan, Inc. 114

 Non-Current (Long-Term) Liabilities
FR56. Maya, Inc. repurchases and retires a series of its corporate
bonds for $990,000. The liability at the time of the repurchase was
$975,000. Maya’s balance sheet also shows a prepaid asset of
$25,000 relating to issuance costs of these bonds. Under U.S. GAAP,
Maya should record a loss of:
A. $10,000.
B. $15,000.
C. $40,000. = $975,000 – $990,000 – $25,000

© Kaplan, Inc. 115

 Non-Current (Long-Term) Liabilities
FR57. A lessor that reports under IFRS will retain the leased asset on
its balance sheet for:
A. finance leases.
B. operating leases.
C. direct financing leases.

© Kaplan, Inc. 116

 Non-Current (Long-Term) Liabilities
FR58. For a lessee reporting under U.S. GAAP, the right-of-use asset
and the lease liability will have equal values over the term of the lease
for:
A. both an operating and a finance lease.
B. neither an operating nor a finance lease.
C. an operating lease but not for a finance lease.

© Kaplan, Inc. 117

 Non-Current (Long-Term) Liabilities
FR59. Which of the following statements about a defined benefit
pension plan is least accurate?
A. Pension expense is equal to the employer’s contribution into
the plan.
B. The employer promises a payment stream beginning at retirement.
C. Future payments typically depend on the employee’s final salary
and past service history.

© Kaplan, Inc. 118

 Financial Statement Analysis Review

Financial Statement Analysis (4):

❑ Financial Reporting Quality
❑ Applications of Financial Statement Analysis

© Kaplan, Inc. 119

 Financial Reporting Quality
High-quality financial reporting
Conditions that may lead to low-quality financial reporting
▪ Decision-useful: relevant, faithful representation
▪ Unbiased reporting choices Motivation
▪ Meet analyst expectations
High-quality earnings ▪ Meet debt covenants
▪ Sustainable over time ▪ Incentive compensation
▪ Adequate return on invested capital
Opportunity
▪ Weak internal controls
Bias in financial reporting choices
▪ Inadequate board oversight
▪ Aggressive bias: Choices increase earnings in current
▪ Wide range of acceptable accounting
period, decrease earnings in later periods
treatments
▪ Conservative bias: Choices decrease earnings in current
period, increase earnings in later periods Rationalization
▪ Earnings smoothing: Conservative choices when earnings ▪ Management story that actions are justified
are high, aggressive choices when earnings are low

© Kaplan, Inc. 120

 Financial Reporting Quality
Revenue Recognition Operating Cash Flow
▪ Shipping terms: Free-on-board at origin or destination ▪ Capitalizing purchases: Cash outflow classified as
CFI instead of CFO; also increases current-period
▪ Accelerating orders by offering discounts
earnings compared to expensing purchases
▪ Shipping extra goods to distributors (channel stuffing)
▪ Stretching payables: Delaying payments to suppliers
▪ Bill-and-hold: Recognize revenue for goods not yet shipped can increase CFO in current period
▪ Under IFRS, choice of how to classify dividend and
interest cash flows

Accounting Estimates
▪ Losses from uncollectable accounts
▪ Provisions for warranty expenses
▪ Valuation of deferred tax assets
▪ Long-lived assets: Depreciation methods, useful lives, salvage values, impairments

© Kaplan, Inc. 121

 Financial Reporting Quality
Revenue Recognition Operating Cash Flow
▪ Changes in recognition methods ▪ Ratio of CFO to net income is less than one
▪ Bill-and-hold, barter transactions or declining over time

▪ Revenue growth, profit margins out of line with peers

Other Warning Signs
▪ Decreasing receivables turnover, total asset turnover
▪ Management emphasis on “pro forma” or other non-GAAP
▪ Non-operating or one-time gains included in revenue earnings measures
▪ Related party transactions
▪ Fourth-quarter earnings increases not caused by
Inventories
seasonality of business
▪ Declining inventory turnover ratio
▪ “Non-recurring expenses” appear regularly
▪ Under LIFO with increasing prices, inventory
▪ Minimal disclosure
drawdown results in artificially low COGS and high
gross margin in current period ▪ Large number of acquisitions

© Kaplan, Inc. 122

 Financial Reporting Quality

Complete questions: FR60-FR65

Time allocated: 7.5 minutes

7.5 5 2.5 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

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© CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.

FR60. If a company uses a non-GAAP financial measure in an SEC

filing, then the company must:
A. give more prominence to the non-GAAP measure if it is used in
earnings releases.
B. provide a reconciliation of the non-GAAP measure and
equivalent GAAP measure.
C. exclude charges requiring cash settlement from any non-GAAP
liquidity measures.

© Kaplan, Inc. 124

 Financial Reporting Quality
FR61. Which of the following would lead to a one-time boost to cash
flow from operations?
A. Increasing inventory levels.
B. Shipping goods on the last day of the accounting period on the
terms “free on board shipping point.”
C. Delaying payment to suppliers beyond existing credit terms.

© Kaplan, Inc. 125

 Financial Reporting Quality
FR62. Which of the following statements about financial reporting
quality is least accurate? earnings quality
A. High financial reporting quality means earnings are high and
sustainable in the long run.
B. Low financial reporting quality impedes assessment of earnings
quality and valuation.
C. High earnings quality increases company value.

© Kaplan, Inc. 126

 Financial Reporting Quality
FR63. High-quality earnings most likely reflect:
A. material non-recurring items.
B. sustainable activities generating an adequate level of return.
C. information that is complete, neutral, and free from error.

© Kaplan, Inc. 127

 Financial Reporting Quality
FR64. Which of the following best describes the conditions that are
conducive to issuing low-quality or even fraudulent financial reports?
A. Incentives and pressures; opportunity; moral hazard.
B. Opportunity; accounting ability; moral hazard.
C. Opportunity; motivation; rationalization.

© Kaplan, Inc. 128

 Financial Reporting Quality
FR65. Which of the following reduces operating cash flow but
increases financing cash flow?
A. Borrowing money from a bank to repay suppliers.
B. Delaying payment to suppliers.
C. Opting to classify interest paid as a financing cash flow

© Kaplan, Inc. 129

 Financial Statement Analysis: Applications
Analyst Adjustments

Investments
Held-to-maturity Purpose:
Available-for-sale Comparability
Trading
Inventory
FIFO/LIFO/average cost
Property, Plant, and Equipment
Depreciation methods
Estimated lives
Salvage values
IFRS allows revaluation model
Goodwill
Internally generated: Not capitalized
Purchased: Capitalized
Off-Balance-Sheet Finance
Equity accounted SPEs vs. non-qualifying SPEs
Sale of accounts receivable

© Kaplan, Inc. 130

 Financial Statement Analysis: Applications

Complete questions: FR66 and FR67

Time allocated: 3 minutes

3 2 1

Approximate minutes remaining

If you need extra time, simply pause the presentation near the end of the allotted time.

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© CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.

FR66. An analyst gathered the following data for a company ($ millions):

31 Dec 2000 31 Dec 2001
Gross investment in fixed assets $2.8 $2.8
Accumulated depreciation $1.2 $1.6

The average age and average depreciable life of the company’s fixed assets
at the end of 2001 are closest to:
Average age Average depreciable life
A. 1.75 years 7 years
B. 1.75 years 14 years
C. 4.00 years 7 years

Depreciation expense = $1.6 million – $1.2 million = $400,000

Average age = $1.6 million / $400,000 = 4 years
Average depreciable life = $2.8 million / $400,000 = 7 years
© Kaplan, Inc. 132
 Financial Statement Analysis: Applications
FR67. Which of the following business characteristics is least likely
considered part of a firm’s capacity to repay debt?
A. Scale and diversification.
B. Margin stability.
C. Corporate governance. Considered part of character

© Kaplan, Inc. 133