CFA Level 1 (2009) - 3

Srudy Session 10

Cross-Rcferencc to CFA Institute Assigned Reading #43 - International Standards Convcrgcnce

As an example, consider a U.S. firm Ihar reports ils inventory under LIFO and an Ir:JZS ftrm lhar repons ils invtlnlory under I~l FO. The inUlllle SI,l!emenlS and bahnce shecrs or lhe lWO firms cannor bc compared wilhoul recasling rhe II:RS (irm's financial SLllcmcnlS 10 U.S. CAAP or vice versa. BCC;1l1SC I.IH) ftrms arc required lO disclose rhe L.lH) resnve in rhe financial Slaleml'nl foolnoles, il is usu;llly easier lO convert the LIFO firm SLIIl'llll'nlS It) a nH) basis.

1n ;111 infLllionary enviwllillenl, a LIFO firm will repo[{ higher cues and lower invenlory as compared III a FIFO firm. Higher coes will resulr in lower profIrabililY (gross profir, operaring profir, laxahle profir, and nel profir). Lower laxable [Hofir will resulr in lower income r;\Xes. LOVin nCl profir will also resull in lower equiry (lower rcrained earnings).

The UFO reserve is lhc difference bcrwecn LlH) and FIFU invcntory. By adding rhe 1.1 FO reserve lO rhe U.S. firm's invenrory balancc, lhe :1na!ysr can Slarc the U.S. firm's inventory on a FIFO basis lO make ir comparahle \virh rhe JI:RS ftrm.

In ;,ddilion, it is I1L'l"l'SS;}!\ 10 U1Jl\'l'I"l I.JFO coes to l-'lH)CUCS. This c;ln he xC(JlJ)plishul hy SUhlLlllil1g the illlle;lsc in till' I IH) reserve over lhl' period from l.IH) CO<S

Example: LIFO adjustments for comparison purposes

Brownfield Company is:1 LIFO firm, Ar rhe end of last year, Brownfield reported inventory of $2 million and cosr of goods sold of $6.4 million. Brownfield's LIFO reserve was $600,000 ar [he beginning of the year and $900,000 at year-end. Calculare Brownfield's COGS and ending invenrory on a FIFO basis.

Answer:

The UFO reserve increased $300,000 over the year [$900,000 - $600,000]. By subtracting the increase in the LIFO reserve from LIFO COGS, COGS on a FIFO basis is $6.1 million [$6.4 million - $300,000].

By adding rhe LIFO reserve of $900,000 to Brownfield's LIFO inventory of $2 million, inventory on a FIFO basis is $2.9 million [$2 million + $900,000J.

Adjustments to LIFO inventory and UFO COGS (in an inflarionary environmenr) to their FIFO equivalents will result in:

• Higher gross profit margin [(revenue - COGS) / revenue] because of lower COGS.

•Higher operating proGr margin [operaring profir / revenue] because of higher gross proG r.

Higher ncr profir margin [ner income / revenue] because of higher operating profit.

•Higher currenr rario [currenr asser / currenr liabiliries] because of higher currenr assets (inventory).

•Lower toral asser turnover ratio [revenue / average wtal assers] because of higher toral assers (inventory).

Lower inventory turnover rario [COGS / average inventory] because of lower COGS and higher inventory.

•Lower debt-ro-equity rario because of higher equity.

Study Session 10

Cross-Refercnce to CFA Institutc Assigned Reading #43 - Intcrnational Standards Convergcl\c,",

l.OS -i).a

Ildd-ror-trading sccuritics arc reported at rail' valuc on the balance shcer and any uIJrl'ali.,.cd gains and losses :Ire rl'ulgnized in the income Sl:llell1l·nr.

The cqllity ll1ethod is used for husinl'ss combinations when !he invesror can significantly inHucnce rhc invcsree (betwecn 20% and ')()(Xl ownership intell:st). The consolidation mcthod is used when the invesror can conrrolthe investee (greatcr rhan 5()o;(l ownership interest). [n rhe case of joint cOI1lrol, proportionate consolidarion is preferrcd under

[FRS, bur the equiry method is required under

Inventory is reported on rIll'bahnle sheet at the lower uf cost or net realizable valuc under IFRS and at the lower or cos! or markcr under U.S. CAAP. A recovery of value :dI!):,c'lucnl [0 a writl'llmVll C:IIl llC rccognizcd under IFRS bUI Illl! under U.S. (;/\/\1'.

Under lrlZS, the value of' propeny and equipmcnt and idc'ntili:lhk jnLlngihk asselS can be revalued upward, bur under U.S. CAAP, they Cannot.

10S1)I)

When the firm cannot reliably estimate the OUlcome of a projecr, it rccognizes costs as revenue III lhe extent they arc likely recoverable, bur firms reporting under U.S. eAAP must use rhe completcd connan method.

The LIFO inventory cost method is permirrcd by U.S. CAAP but is prohibitcd undL'!

IFRS.

IFRS requires !he depreciatiun melhnJ [0 allocdle an asset's cost ~ystcl11alicall)'over liS useful life and reAect the pattern of asser consumption.

IFRS docs not permit firms ro treat ircms as "exrraordinary items" on the incomc starcmenr as they can under U.S. CAAP.

lOS /d.c

Under U.S. GAAP, dividends paid are financing acriviries while interest paid or received and dividends received are operaring activities. Under IFR5, dividends and interest paid can be reported as either operating activities or financing activities. Interest received and dividends received can be reported as either operating activities or investing activities.

LUS ilLe!

To compare financial statement ratios of firms reporting under 1..1.5. CAAP and IFRS, an analyst must adjust the data for one of the firms [() make the financial statemellts comparable.

Study Session 10

Cross-Reference to CFA Institute Assigned Reading #43 - International Standards Convergence

l.Arc held-for-trading securities and inlluential securities reported on the balance sheet at fair value?

2.According to the International Accounting Standards Board, should the costs of developing goodwill and the costs of acquiring goodwill be capitalized?

At the end of 20X(1, Toreador Inc. owned c(juipment tint beelIlle impaired. At the time of impairment, the nnrkcr value of the equipment was $150,000 and a $25,000 expense was recognized. At the end of 20X7, the market value of the equipment increased $40,000. Which of the following best describes the effect of the recovery on Toreador's 20X7 financial statements according to the International Accounting Standards Board?

A.Neither net income nor shareholders' equity are affected.

B.Net income increases $25,000 and shareholder's equity increases $40,000.

C. Net income increases $25,000 and shareholders' equity increases $ I 5,000.

4.Bledsoe Construction Company is in the second year of a .C)-year contract to build a new hotel. Due to a labor strike, Bledsoe is unable to reliably estimate the total cost of the project. Can Bledsoe recognize revenue in the first year of

the project according to U.S. accounting standards and inrernational accounting standards?

U.S. accounring standards

A. Yes

B. No

e. No

5.According to the International Accounting Standards Board, where should a firm report interest received and dividends received in the cash flow statement?

A.Operating activities or investing activities.

B.Operating activities only.

e. Neither operating activities nor investing activities.

6.At the end of the year, a firm reported LIFO inventory of $ I 00,000 and cost of goods sold of $320,000. If the LIFO reserve was $30,000 at the beginning of the year and $80,000 at year-end, how much was FIFO COGS?

A.$220,000.

B. $240,000. e. $270,000.

Study Session 10

Cross-Referencc to CFA Institutc Assigned Reading #43 - International Standards Convergence

7.An analyst wants to compare the financial results of a U.S. firm and a European firm. The accounting standards followed by both firms arc the same except that

the European firm revalues its real property upward to refleer fair value. The U.S. I1rl11's real property is reported at historical cost. The analyst decides to reslate the European firm's real property by eliminating the unrealized gains.

What effeer will the restatement haw on the European firm's tOlal asset turnover and ddH-to-cquity rarios?

Total asset turnover

A. I.ower

B. Higher

C. Higher

Study Scssion 10

Cross-Reference to CFA Institute Assigned Reading #43 - International Standards Convergence

I.A A hc1d-for-trading sccurity is n.. ported on thc balance shcct at Ctir nlue. An influcntial

sccurity is accountcd for using the equity IlIcthod. LJndn the equity method, thc halancc

.shcet account is not rCI'Orll'J at fair valuc.

B Till' costs ;tSSOci;lled wilh developing goodwill should hc expcnscd as illCllrrnJ. Thc cost of goodwill acquircd in a husint'ss acquisition is capitalil,l,d.

B The impairnH'nr luss of $2'),000 W:15 reponed in 20X6 nct income, Therefore, $2'),000 of the $40,000 increase in market v:J!ue is reportcd in 20X7 nct inCDIl1C, The relllaindn of $1 '),000 is r"llOrtcd as ;1 direct :ldjnstl11l'llt to sharc1w\dcrs' equity. Total sharcllllldns' l'ljuity incrcases .'qO,OOO; $2'),000 l"rorn nct incolllc (incrcJscs relaincd earnings) and

frolll lhc dircct adjusrmcnl.

i.B Since \jlcdsoc C1l1nOl reasonahly cSlilllall' cost, thc c'Lllllplctn!-conlrau nlcrl1l1d is

rC'lnired nndn [i.S. < ;;\;\]' ,Ind no rn'CIllll'S Hc' rn<lgniznlllillil 11Wjcct cUlllpktiu/l. 111nisol' can USl' I Ill' I'ncl'lllage-<lf-conlilktion mctlwd under IFIZS; Iw\s'l'\'l'l', rl'\Tnlll' IS rl'l'ugnilcd unly tu rllC cxtcnt that custs ;Irl' illlurrcd, Nu prulil C,II1 hc rccu!;llIl.ed ulltil the pmject is 1l1l1l1'Ictl·.

~i~i~~~TEST: F.i~ANGI~·MPo'~ti~;q~'D'~f\ri¥.sts'·:.. ·:.

(:. Information allllut expected C1pital expenditures and evel1lS with liquidity il11 pIica tions.

2.Contractors, Inc. has contracted to build J stadiul1l for the City OfW;lSlOIL The contract price is $100 million, costs arc estimated to be $60 l1lillion, and the til1lL' to compiL'tion is three years. Compared to Ihe cOlllpleted conrract IlIClhod. wh;lt efl'ccr will using the percent;lge-of-nln1plction merhod most li/?ely h;lvc' on a

VC;H 2 leverage LHio ;1l1d year 3 cash !low from oj1CLltions?

A.Both will he the same using either l1lClhod.

B.Bot h wil I lower usi ng pCTcenrJge-of-col11 plcLion.

''I. \\lhich of the following is an analyst Ii'rl.lt likely to bc ahle to lind on or calculate from either a coml1lon-size income st3.te1l1ent or a common-size babnce sheet?

A.Invcntory wrnover.

B.Operating proht margin. e. Debt to equity ratio.

s. 11' a 111'111\ inventorv luJ'JlovL'!' ;lnd IlUnlbCl' or days or 113yables ho(h increase, till"

d"fl:ct on a hrm's cash conversion cycle is:

A.to shorten it.

B.to lengthen it.

C. 1I ncertam.

Self-Test: Financial Reponing and Analysis

6.The following information is summarized from Famous, Inc.'s I1nancial statements for the year ended December 31', 20XO:

Sales were $800,000.

Net proht margin was 20%.

Sales to aSsns was o 50 Al.

Fquity multiplier is I.G.

IlHerest Expense was $30,000.

Dividends declared were $.32,000.

Famous, Inc.'s sustainable growth rate based on results from this period is clost'st

to:

A.:1.2%.

B.8.0<Yo.

C.12.8%.

7.On January 1, Orange Computers isslled employee stock options for 400,000 shares. Uptions on 200,000 shares have an exercise price of $1 8, and options Oil the olhn 200,000 shares have an exncise price of'$22. The year-end swck price was $24, and the average slOck price over the year was $20. The change in [he number of shares used to calculate diluted earnings per share for the year due lO these options is closest to:

A.20,000 shares.

B.67,000 shares.

C.100,000 shares.

A.a UFO liquidation.

B.declining purchase prices.

C. amortization of the LIFO reserve.

9.If a I1rm issues par bonds with warrants attached rather than issuing an equal amOU11l of par convertible bonds with the same coupon rate, it will tend to:

A.improve the I1rm's leverage ratios.

B.decrease ROA prior [0 conversion or warrant exercise.

C.decrease income variability prior [0 conversion or warrant exercise.

10.Train paid $8 miJlion to acquire a franchise at the beginning of 20X5 that was expensed in 20X5. If Train had eleered to capitalize the franchise as an intangible asset and amortize the cost of the franchise over eight years, what effect would this decision have on Train's 20X5 cash flow from operations (CFO) and 20X6 debt -to-assets- ra tio?

A.Both would be higher with capitalization.

B.Both would be lower with capitalization.

C.One would be higher and one would be lower with capitalization.

Self-Test: Financial Reporting and Analysis

11.Craphics, Inc. has a deferred tax asset of $4,000,000 on its books. As oC December 31, it is probable that $2,000,000 of the deferred tax asset's vallie will never be reali/.ed because of the uncertainty about future income. Craphics, Inc. slwlIld:

A.reduce the deferred tax aSSet account by $2,000,000.

B.establish a valuation allowance of $2,000,000.

C.establish an offserring deferred tax liability of $2,0()(),O()O.

12.Which of the folJowing was Letlst Likely a financial reporting quality warning sign related to the Sunbeam accounting scandal?

A.Improper bill-and-hold transactions.

B.Creating excessive reserves in a period of poor earnings.

C.Investing cash flows much higher than operating cash !lows.

13.If Lizard Inc., a lessee, treats a 5-year lease as a finance lease with straightlinc depreciation rather than as an operating lease:

A.it will have greater equity at lease inception,

B. its operating income will be less in the first )'(:'al o( tit,· Ie~(s<'.

C. its CH) will bc greater and eFt: will be less in tlte se,ond year of tile leiS".

14.Compared to a long-lived asset with no costs of disposal, an otherwise identical asset that has significant expected environmental remediation costs at the end of

A.net income.

B.0perallng mcome.

C.taxes payable.

16.Under U.S. CAAP, firms arc required to capitalize:

A.any 3.sset with a useful economic life of more than one year.

B.interest paid on loans to finance construction of a long-lived asset.

C.research and development costs for a drug that will almost certainly provide a reven tie stream of five years or more.

17.With regard to the exercise of employee srock options, which of the following is

least likely a concern to the analyst?

A. Il1creased operating cash flow from the tax benefits of exercise of the options.

B.Effects of exercise on investing cash flows.

C. Classification of the cash flow to repurchase shares.

Self-Test; Financial Reporting and Analysis

18.During a period of falling prices and stable invcnrory CJuantities, what arc the dle<1ts on net income and cash How of using FIFO inventory accounting (for financial and tax reponing) as compared to LI I{) for a 11rm reponing under U.S. CAAP?

A.Both arc higher using I:IfO.

B.Both arc lower using FIFO.

C. One is higher and one is lower using FIH).

.~(). Viuory Corp. rl"Ccived inreresl incon1L' lrom kdnally tax exempt bonds o( $40,000 in the vcar 20XO. Its SLlIutory [;LX rare is .'iO'!(). The eifel! of I hi, dilTereme belwel'n laxable and pre-lax incomc' is It/OJ! /;kdj' a(n):

A.decrease in ils effective lax rate to below ;jO%.

B.increase in its deferred tax asset of $16,000.

C.increase in its deferred tax liability of $16,000.

21.The effects of creating a sale of receivables with recourse as a borrowing agai nst receivables are /C(lSt /i/~f~Y to include:

A.increasing the rotal debt ratio.

B.decreasing the receivables turnover ratio.

C.reducing the value of cash and marketable securities.

22.A li.nn based in Germany that prepares its financial statements under IFRS hut issues publicly traded securities in the Unitcd States:

A.is required by the SEC to prepare financial statements in accordance with U.S. GAAP.

B.must prepare separJ.te financial statemcnts, one undt'r IJ~RS and onc under

U.S. GAAP.

C. can either prepare a set of financial statements under U.S. GAAP or include a reconciliation ofIFRS statement items with their GAAP equivalents and reJated disclosures.

23.An analyst is comparing two firms, one that reports under II~RS and one that reports under FASB standards. An analyst is least likely to do which of the

following to facilitate comparison of the companies?

A. Add the LIFO reserve ro inventory for a U.S.-based firm that uses

B.Add the present values of each firm's future minimum operating lease paymen ts to both assets and liabilities.

C.Adjust the income statement of one of the fi.rms if both have significant unrealized gains or losses from changes in the fair values of trading seCUrIttes.

Self-Test: Financial Reporting and Analysis

24.An analyst wants to compare the cash flows of two U.S. companies, one that repons cash flow u~ing the direct method and one that repons it using the indirect method. The analyst is most likely to:

A. convert the indirect statement to the (lirect method to comparc rhe firms'

cash expenditures.

B. adjust the reponed CFO of the firm that rcpo[{s ulIlkr the direct mct hod for depreci;nion and amortization expensc.

C.increase CFl (or any dividcnds reporled as investing cash flows by rlll: firm reporting cash How by the direer mcthod.