CFA Level 1 (2009) - 3

Study St:ssioll R

B.Depreciation expense will be higher in the first year.

C.Scrapping the equipment ;If"ter rive years will result in a larger loss.

9.CC Corporation reported t he following inventory transactions (in ch rono logical order) for the year:

Assuming inventory at the beginning of the year was zero, calculate the year-end inventory using FIFO and LIFO.

A.$5,250.

B.$6,250.

C.$7,000.

11.Which of the following is least likely considered a nonoperating transaction from the perspective of a manufacturing firm?

A.Dividends received from available-for-sale securities.

B.Interest expense on subordinated debentures.

C.Accruing bad debt expense for goods sold on credit.

12.Changing an accounting estimate:

A.is reported prospectively.

B.requires restatement of all prior-period statements presented in the current financial statemen ts.

C.is reported by adjusting the beginning balance of retained earnings for the cumulative effect of the change.

Sludy Sc~sion R

Cross-Rcfercnce to CIA Institute Assigned Reading #32 - Understanding the Income Statement

of rhe beginning of the year. The lax rare is 40%.

The company's diluted FPS is closC5t to:

A.$1.22.

B.$1.25.

C $1.34.

Sludy Session R Cross-Rcrercnc~ to erA Institute Assigncd Rcading #32 - Understanding the Income Statement

18.An analyst has gathered the following information about a company:

•Stock is selling ar year end for $25.

•The average price of the company's slOck for the year was $1 ').

How many sltares should be used in calculating rhe COl11pallY"s dilurcd FilS?

A.16,667.

B.50,000.

C. 66,667.

19.To sllldy trends in a firm's cost of goods sold (COGS), the analyst should standardize cost of goods sold by dividing it by:

A.sales.

B.nct lllcome.

c:. prior year C:OCS.

20. Willch of rhe following ratios is ~I lIleasure of profllabilltyi

A.CUITcnr LHio.

B.Fixed asset turnover ratio.

e.Pre-tax margin ratio.

21.\X!hich of the following rransaetions affects owners' equilY but docs not affeer nel income?

A.Foreign currency translalioll gain.

B.Repaying the face amount on a bond issued at par.

C.Dividends received from available-For-sale securities.

22.Which of the following is least likely 10 be included when calculating comprehensive income?

A.Unrealized loss from cash How hedging derivatives.

B.Unrealized gain from available-far-sale securities.

C.Dividends paid to common shareholders.

Study Session R

Cross-Reference to CI~A Institute Assigncd Reading #32 - Understanding the Incomc Statement

BDepreciation is included in tlte UlIllpllLllion or oper;lling cxpenses. Interest expcnse is a rin~tll'ing cost. Titus, il is cxclud"d frol11 0IJLrating exPl'tlScs.

'J A Incol11c taxcs arc expcnscs grouped togcther LJy thl'ir n;llllrl'. Cost or gl}()ds sold illl:llIdes a nlll11lll'r or l'XpCI1Sl'S related to thc sal11e function, thc production of illvclltlJry.

). A In order 10 recognizc revcnue, the selIcI' I11USt know thc s;des price and he re;lsonahJy sllre of collection, and Inllst have delivercd thc goods or rendercd the scrvicl'. Actllal collection of" cash is not rcquircd,

Ij. A $2/j,OOO/%O,OOO ~ 1\0% of" the IHojecl completed. 'iO% of S100,000 ~ S'W,OOO rcvl'l1ue. $40,000 rcvenuc -- $24,000 cost = S Hi,OOO prollt f"or th,' period. No prulil would bc rcportcd in the first ye;tr usill S the c()ll1plcl,·d CLJnlL1Ll ll1ethod.

S.C The IlLll,l,inf; prillciple 'C'luires l!LIl IhL' expenses inulrrL·d 10 gl'ner;l[e the rL'I"elllll' he reLognil.l'l1 in Ihe S.lI11C acullinling period .IS the revenlle.

(). C Decrcasing tltc residual (salvage) vailic of a depreciable long-lived assel will result in higher dcpreciarion expense and, thus. lower pretax il1come.

/.A UFO al1ll F1rO are hoth permitted under U ..s. c;i\AP. LIFO is prohihited under fFlZS.

R.B Accelerated depreciation will result in higher depreciation in the early years and lower depreciation in the later years compared to the straight-line method. Total depreciation expcnse will be the same under hoth methods. The book value would be higher in the latcr years u,ing straight-line depreciarion, so the loss from scrapping the cquipnlcill under an accelerated merhod is Jess compared rhe straight-line 111ethod.

t). B lOR units were sold (13 + 35 + 60) and 150 units were available (or sale (beginning

12.A A change in an accounting estimate is teported prospectively. No reSr;ltement of prior period statements is necessary.

13. C A physically and operationally distinct division that is currently for s~le is treated as a discontinued operation. The income from the division is reponed net of tax below income from continuing operations. Changing a depreciation method is a change of

accounting principle, which is applied retrospectively ~nd will change operating income.

14.C A change in accounting principle requires retrospective application; that is, all prior period financial starements currently presented ~re restated to reflect the change.

Study Session H

19.A In a common-size income Statement, each income statement account is divided by sales. coes is thell production costs as a percentage of price_

20.C Pre-tax margin (pre-tax earnings / revenue) measllles profitability.

21.A A foreign currency translation gain is not included in ner income but the gain increases owners' equiry. Dividends received are reported in the income statemCI1[. The repayment of principal does not affect owners' equity.

22.C Comprehensive income includes all changes in equity except transactions with shareholders. Therefore, dividends paid to common shareholders are not included in

com prehcnsive income.

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The following is a review of the l'inalH:ial Reporting and Analysis principles designed to address lhe learning OIHcome statelllelllS set forrh by CFA Institutec'J. This topic is also covered in:

UNDERSTANDING THE BALANCE SHEET

Study Sl'ssion 8

EXAM FOcus

lOS .:n.a: Illustrate and interpret the components or the ;lssctS, jiabiliric;;, ;llld celllit)' sections of the halancc shcet, and discuss thc uses of the balance sheet in financial analysis.

Assets provide probable fLltllfe economic benefits controlled by an entity as a result of prevIOus transactions.

Assets can be created by operating ;lnivities (e.g., generating net Income), investing activities (e.g., purchasing manufacturing equipment), and financing activities (e.g., issuing debt). Figure 1 lists some of the more common asset accounrs found on the balance sheet.

Figure 1: Common Balance Sheet Asset Accounts

Cash and equivalents

Accounts receivable (trade receivables)

Inventory

Prepaid expenses

Investments

Property, plant, and equipmel1l

In tangible assets

Deferred tax assets

Pension assets

Study SessioIl H

Cross-Reference to CFA Institute Assigned Reading 1133 - Understanding the Balance Sheet

Liabilities arc ohligations owed hy an entity from previous transacrioIlS that arc expected

l

ro result in an oudlow of economic henefits ill the future.

I.iahilitie.~ arc creared by [Imncing activiries (c.g., issuing deht) ~lnd operating JCtivities (c.g., recognizing expense hefore p;lYl1lent is made). hgure 2 lists some of d1l' mOll' UlnlI110n liability accounts found in the balance shee!.

Figure 2: Common Balance Sheet Liability Accounts

Accounts payable (trade paY'lbles)

Accrued ex peIlSe'S

Unearned revenue

No!es payahle

Bonds parable

C'll)iul (fill'lIlcial) !c'lse ()hli~aliom

Pension I,.lhilities

L)ckrred LIX liahilities

_._------~-.. - ~--

Inherent in the definition ofborh assets and liabilities is rhar a fllture economic imlJacr is probable and can be reliably measured.

Stockholders' equity is rhe residual interest in assets rhat remains after suhtracting a hrm's liabiliries. Stockholders' equiry is also referred (0 as "shareholders' equity" and "owners' equity," or sOl11enmes just "equiry" or "ncr assers.

Equity is created by financing activities (e.g., issuing capical srock) and by 0IJerating acrivities (e.g., generating net income). Figure 3 lists some of the more common equit)' accoullCS found in the balance sheet.

Figure 3: Common Balance Sheet Equity Accounts

Capital stock

Additional paid-in-capital (capital in excess of par)

Treasury srock

Rerained earnings

Accumulated other comprehensive income

The balance sheet is important to investors and lenders alike. However, the analyst must understand its limitations. Noc all assets and liabilities are reported on che balance sheet, and those that are not necessarily reported at fair value.

LOS 33.b: Describe the various formats of balance sheet presentation.

There is no standardized balance sheet format. However, two common formats are the account format and che reporr format.

Study Sessioll ~

Cross-Refercncc to erA Institute Assigncd Reading #33 - Undcrstanding the Balance Sheet

Just lik<: th<: balance sh<:n equarion, an account format is :l bYOtn in which assets are pr<:sclHcd on the lefr lund side or rh<: page and liabilities and Clluity arc pn:sen((~J 011 the right hand side. In a report format, the assetS, liabilities, and clluity arc pres<:nrcd in olle column.

A classified balance sheet gtOUps together similar itcms to ~lrrive :It significanr mbrotals. I:or cxamplt, CUHenr assets arc grouped together and currellt liabilities arc grouped rog<:ther. Similarly, noncurrent asscrs arc grouped together, as arc 1l0nClIl'renr liabilities.

LOS .l.~.c: Explain how assets and liahilit ies arise from the aecrl1:l1 process.

----_.~-----~._-----~~--~-----~----------

/I.sse[s and liabilities arc created hy business rraI1S:lCllons. ror example, if:l firm issues bonds in exchange for cash, assels (cash) increase and liabilities (bonds payable) increase by the same amount.

The ~ll'l'llall11elhodor ~Kcoufl[ing also creares assets and liahiJiries. Ullder accrual alLllllnting, revenue recognition and l'Xpense recognition do 1l0t nt'Ccssarily coinciJe with cash rec<:iprs and cash paymenrs. In particular:

Cash received in advance of recognizing revenue results in an increase in assets (cash) and an increase in liabilities (une:lrned revenue). Once the revenue is earned, liabilities (unearned revenue) decrease and equity (retained earnings) increases. Recognizing revenue before clsh is received resulrs in all increase in asscrs (accounts receivable) and an increase in equity (retained earnings). Once the cash is collected, an asset (cash) increases and another asset (accounts receivable) decreases by the same amount.

Cash paid in advancc of recognizing an expense results in a decrease in onl: asset (cash) and an increase in another asset (prepaid expenses) by the same amount. Once the expense is recognized, assets (prepaid expenses) decrease and equity (retained earnings) decreases by an equal amount.

•Recognizing an expense before cash is paid results in an increase in liabilities (accrued expenses) and a decrease in equity (retained earnings). Once the expense is paid, assets (cash) decrease and liabilities (accrued expenses) decrease by an equal amount.

LOS 33.d: Compare and contrast current and noncurrent assets and liabilities.

Current assets include cash and other assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater. The operating cycle is the rime it takes to produce or purchase inventory, sell the product, and collect the cash. Current assets are usually presented in the order of their liquidity, with cash being the most liquid. Current assets reveal informarion about the operating activities of the firm.

Current liabilities are obligations that will be sarisfied within one year or one operating cycle, whichever is greater. More specifically, a liability that meets any of the following criteria is considered current:

•Settlement is expected during the normal operating cycle. Settlement is expected within one year.

•There is not an unconditional right to defer settlement for more than one year.

Sl lIdy Session 8

Cross-Reference to CFA Institute Assigned Reading #:l3 - Understanding the Bahmce Sheet

Currenr asscts minus current liabililies equals working capital. Not enough working capilalmay indiclle liquidilY problems. Too much working capilal may be an indication or indhcienl use of assels.

Noncurrent assets do nOI meet Ihe definition of CUlTelll assets because they will not be convened into cash or used up within one year or oper~llingcycle. Noncurrent asselS provick information about the firm's invesling activities, which form the foundalion upon which the firm operates.

Noncurrent liabilities do nOl l11eet the criteria of current liabilities. Noncurrent liabilities provide information about the firm's long-term financing activities,

lmernational Financial Reponing Standards (ll-'RS) requires the currenr/noncurrenr format unless a liquidity-bascd presentation is more rclevanr, as in the banking indusLrY.

If'a firm has a conlrolling interest in a subsidiary rhar is nor 1l)()<Y;, owned, the parl'nl reports a minoriry (nonconrrolling) inrerest in its consolidated b;tlance sheer. The minority interest is the pro-rata share of rhe subsidiary's net assets (equity) not owned by the paren t company.

Under lFRS, the minority interest is reponed in the equity section of the consolidated balance sheer. Under U.S. CAAP, the minority interest can be reponed in the liabiliries seerion, the equity seerion, or the "mezzanine seCtion" of the balance sheer. The mezzanine section is located between liabilities and equity.

IJ}'s .ne Explain the Il1ca~;lIrementba~es (e.g., historical cost alld Fair valuc) of assets and liabilities, including current assets, current liabilities, tangible assets, and intangible aSSl"'ts.

Under current accounting standards, the balance sheet contains a mixture of historical costs and fair values, In addition, sometimes replacement cost and the present value of future cash Rows arc used 10 measure assets and liabilities.

Historical cost is the value that was exchanged at the acquisition date. Historical cost is verifiable and objective; however, its relevance to investment analysis declines over time as prices change.

Fair value is the amounr at which an asset can be bought or sold, or a liability can be incurred or settled, between knowledgeable, willing parties in an ann's-length rransaction. Fair value is subjective to a significant extent.

Because of this mixture of measurement bases, the balance sheet value of total assets should not be interpreted as the value of the firm. Analysts must adjust the balance sheet to better assess a firm's investment potential or creditworthiness,

Specific assets and their related liabilities are not usually offset (netted) on the balance sheet. For example, if a firm purchases manufacturing equipment for $3 million that is subject to a loan of $2 million, the asset and liability are shown separately on the balance sheet rather than reponing a net asset value of $1 million.

SUlll YSl'ssion H

Cross-Reference to efA Institute Assigned Reading 1133 - Understanding the Balance Sheet

The financial statement footnotes should include the jl)llowing inllHmation about the

measureml'nt of the firm's assets and liabilities: I

Hasis for ml'aSUrClllc'nr.

Carrying value ofinvenrory by category,

Anj()[lllt of inventory carried at Elir value less costs to scll.

\Xlrile-downs and revns;t!s, wilh a discussiun of the cirCUI1lSLlIlCeS th:lt led tll them. Inventuries pledged as collateral for li:lhilities.

lnventories recognized as an expense.

Current Assets

Current ,IsseIS include cash ;llid other ;lssets that will be converted inro cash or used up within one year or the firm's operating cycle, whichever is greater. Some of the more common current assets include the following:

Cash and clsh equiv;llcnts (liquid low-risk securities with maturities Ic-ss th:1I1 l)O days) .

Accounts receivable (Irade rec'civables)--:llllOUlllS expected to he co!lcctc,ci from rill' sale of goods and services. Receivables are typically reported net of an allowance Illr had debt (net receinbles). This is not considered offscrting because of the nature of the al1owance.

Inventories-items held for sale or used in the manuLtcturing of goods [0 be sold. Manul~lcruringfirms separarely report inventories or raw materials, work-in-process, and finished goods.

Marketable securities~--debtor equity securities that are traued in a public market (e.g., Treasury securities, cerrain equity securilies, and J1lutua) funds).

Other current assets including prepaid expcnses.

Inventory is reponed at thc lower of cost or net realizable value. Net realizable value is the selling price of the inventory less the estimated cost of completion and disposal costs. For a manufacturer, inventory cost includes direct materials, direct labor, and overhead. Inventory cost excludes the following:

Abnormal amounts of wasted materials, labor, and o\'crhe;ld.

Storage COStS beyond the production process.

Administrative overhead.

•Disposal (selling) costs .

As discussed in the topic review on understanding the income statement, the cost Row assumption (i.e., FIFO, LIFO, average cost, or specific idenrification) affects the carrying (book) val ue of the inventory.

Standard costing and the retail method arc used by some firms to measure inventory. Standard costing, often used by manufacturing firms, involves assigning predetermined costs to goods produced. hrms that usc the retail method measure inventory at retail prices and then subtract gross profit in order to reflect cost.

Prepaid expenses arc operating costs that have been paid in advance. As the costs are actually incurred, an expense is recognized in the income statement and prepaid expenses (an asset) decrease. For example, if a firm makes an annual rent payment of $400,000

;.1I the beginning of the year, an asset (cash) decreases and another asset (prepaid rent)