CFA Level 1 - Financial Reporting & Analysis (FRA) Flashcards

Question 1

Three Main Financial Statements & Interrelationships

Accepted Answer

1. **Income Statement**: Measures financial performance over a period of time.
2. **Balance Sheet**: Shows financial position (Assets = Liabilities + Equity) at a single point in time.
3. **Cash Flow Statement**: Tracks cash inflows/outflows over a period.

**Interrelationships**:
- **Net Income** from the Income Statement flows into **Retained Earnings** on the Balance Sheet and serves as the starting point for Cash Flow from Operations (indirect method).
- **Ending Cash** on the Cash Flow Statement equals Cash on the Balance Sheet.

Question 2

IFRS vs. US GAAP: Inventory Valuation Methods

Accepted Answer

- **IFRS**: Allows FIFO, Weighted Average Cost, and Specific Identification. LIFO is **strictly prohibited**. Inventories are measured at the lower of cost or Net Realizable Value (NRV).
- **US GAAP**: Allows FIFO, Weighted Average, Specific Identification, and **LIFO**. Lower of cost or market (LCM) is used for LIFO/retail inventory; lower of cost or NRV is used for other methods.

Question 3

LIFO Reserve & LIFO to FIFO Conversion Formulas

Accepted Answer

The LIFO Reserve is defined as: $	ext{LIFO Reserve} = 	ext{Inventory}_{	ext{FIFO}} - 	ext{Inventory}_{	ext{LIFO}}$

**Conversion Adjustments**:
- $	ext{Inventory}_{	ext{FIFO}} = 	ext{Inventory}_{	ext{LIFO}} + 	ext{LIFO Reserve}$
- $	ext{COGS}_{	ext{FIFO}} = 	ext{COGS}_{	ext{LIFO}} - \Delta	ext{LIFO Reserve}$
- $	ext{Retained Earnings}_{	ext{FIFO}} = 	ext{Retained Earnings}_{	ext{LIFO}} + 	ext{LIFO Reserve} 	imes (1 - t)$

Question 4

Impact of Inflation on FIFO vs. LIFO

Accepted Answer

Under rising prices and stable or increasing inventory quantities:
- **FIFO**: Assigns older, lower costs to COGS $\rightarrow$ **Lower COGS**, **Higher Net Income**, **Higher Ending Inventory**, **Higher Tax Liability**.
- **LIFO**: Assigns recent, higher costs to COGS $\rightarrow$ **Higher COGS**, **Lower Net Income**, **Lower Ending Inventory**, **Lower Tax Liability** (creates tax savings via LIFO conformity rule).

Question 5

Depreciation Methods & Formulas

Accepted Answer

- **Straight-Line**: $\frac{	ext{Cost} - 	ext{Residual Value}}{	ext{Useful Life}}$
- **Double-Declining Balance (DDB)**: $	ext{Book Value} 	imes \left(\frac{2}{	ext{Useful Life}}ight)$ *(Ignores residual value initially, but asset is not depreciated below residual value)*.
- **Units-of-Production**: $\frac{	ext{Cost} - 	ext{Residual Value}}{	ext{Total Estimated Units}} 	imes 	ext{Units Produced}$

Question 6

IFRS vs. US GAAP: Cash Flow Statement Classification

Accepted Answer

| Item | IFRS Classification | US GAAP Classification |
|---|---|---|
| **Interest Paid** | Operating or Financing | Operating |
| **Interest Received** | Operating or Investing | Operating |
| **Dividends Paid** | Operating or Financing | Financing |
| **Dividends Received** | Operating or Investing | Operating |
| **Taxes Paid** | Operating (unless linked to Inv/Fin) | Operating |

Question 7

Direct vs. Indirect Method for Cash Flow from Operations (CFO)

Accepted Answer

- **Direct Method**: Reports actual cash receipts (e.g., cash collected from customers) and cash payments (e.g., cash paid to suppliers/employees). Preferred by standard setters.
- **Indirect Method**: Starts with Net Income and adjusts for non-cash expenses, non-operating gains/losses, and working capital changes:
$$	ext{CFO} = 	ext{Net Income} + 	ext{Depreciation/Amortization} - 	ext{Gains} + 	ext{Losses} - \Delta	ext{Non-Cash Working Capital}$$

Question 8

Revenue Recognition 5-Step Model (IFRS 15 / ASC 606)

Accepted Answer

1. **Identify** the contract(s) with a customer.
2. **Identify** performance obligations in the contract.
3. **Determine** the transaction price.
4. **Allocate** the transaction price to individual performance obligations.
5. **Recognize** revenue when (or as) the entity satisfies a performance obligation.

Question 9

Impairment of Long-Lived Assets (IFRS vs. US GAAP)

Accepted Answer

- **IFRS**: Tested annually or when triggers occur. Impaired if $	ext{Carrying Value} > 	ext{Recoverable Amount}$ (where Recoverable Amount = $\max(	ext{FV less costs to sell}, 	ext{Value in Use})$). **Reversals allowed** up to original cost.
- **US GAAP**: 2-step test:
  1. *Recoverability test*: Impaired if $	ext{Carrying Value} > 	ext{Undiscounted Future Cash Flows}$.
  2. *Loss calculation*: Loss = $	ext{Carrying Value} - 	ext{Fair Value}$. **Reversals prohibited** for held-for-use assets.

Question 10

Capitalizing vs. Expensing Costs

Accepted Answer

- **Capitalize**: Cost recorded as an asset on the Balance Sheet if it provides probable future economic benefits over multiple periods. Increases assets/equity initially, creates future depreciation expense, and classifies outflow as **CFI**.
- **Expense**: Recognized immediately on Income Statement if benefit is consumed in current period. Reduces current Net Income and classifies outflow as **CFO**.

Question 11

Lease Accounting: IFRS 16 vs. US GAAP Topic 842

Accepted Answer

- **IFRS 16**: All leases (except short-term or low-value) are reported on balance sheet with a **Right-of-Use (ROU) Asset** and **Lease Liability**. Single model: all leases treated like finance leases (depreciation + interest expense).
- **US GAAP**: Dual classification (**Finance** vs. **Operating**). Both recognize ROU Asset and Liability, but Operating Leases report single straight-line expense on Income Statement.

Question 12

Off-Balance-Sheet Financing: Definition & Examples

Accepted Answer

**Definition**: Financial transactions or arrangements where assets or liabilities do not appear on a company's balance sheet, used to keep leverage ratios artificially low.

**Common Examples**:
- Take-or-pay agreements
- Factoring accounts receivable with recourse
- Special Purpose Entities (SPEs) or Variable Interest Entities (VIEs) not consolidated
- Joint ventures accounted for under equity method

Question 13

Liquidity Ratios

Accepted Answer

- **Current Ratio**: $\frac{	ext{Current Assets}}{	ext{Current Liabilities}}$
- **Quick Ratio**: $\frac{	ext{Cash} + 	ext{Marketable Securities} + 	ext{Receivables}}{	ext{Current Liabilities}}$
- **Cash Ratio**: $\frac{	ext{Cash} + 	ext{Marketable Securities}}{	ext{Current Liabilities}}$

Question 14

Activity Ratios (Efficiency Ratios)

Accepted Answer

- **Inventory Turnover**: $\frac{	ext{COGS}}{	ext{Average Inventory}}$ ($	ext{DOH} = \frac{365}{	ext{Inventory Turnover}}$)
- **Receivables Turnover**: $\frac{	ext{Revenue}}{	ext{Average Receivables}}$ ($	ext{DSO} = \frac{365}{	ext{Receivables Turnover}}$)
- **Total Asset Turnover**: $\frac{	ext{Revenue}}{	ext{Average Total Assets}}$

Question 15

Solvency Ratios

Accepted Answer

- **Debt-to-Equity**: $\frac{	ext{Total Debt}}{	ext{Total Equity}}$
- **Debt-to-Assets**: $\frac{	ext{Total Debt}}{	ext{Total Assets}}$
- **Interest Coverage Ratio**: $\frac{	ext{EBIT}}{	ext{Interest Expense}}$
- **Financial Leverage Ratio**: $\frac{	ext{Average Total Assets}}{	ext{Average Total Equity}}$

Question 16

3-Way DuPont Analysis of ROE

Accepted Answer

Decomposes Return on Equity into three components:
$$	ext{ROE} = \left(\frac{	ext{Net Income}}{	ext{Revenue}}ight) 	imes \left(\frac{	ext{Revenue}}{	ext{Average Assets}}ight) 	imes \left(\frac{	ext{Average Assets}}{	ext{Average Equity}}ight)$$
$$	ext{ROE} = 	ext{Net Profit Margin} 	imes 	ext{Asset Turnover} 	imes 	ext{Financial Leverage}$$

Question 17

5-Way DuPont Analysis of ROE

Accepted Answer

Breaks down profit margin into tax burden, interest burden, and operating margin:
$$	ext{ROE} = \left(\frac{	ext{Net Income}}{	ext{EBT}}ight) 	imes \left(\frac{	ext{EBT}}{	ext{EBIT}}ight) 	imes \left(\frac{	ext{EBIT}}{	ext{Revenue}}ight) 	imes \left(\frac{	ext{Revenue}}{	ext{Average Assets}}ight) 	imes \left(\frac{	ext{Average Assets}}{	ext{Average Equity}}ight)$$
$$	ext{ROE} = 	ext{Tax Burden} 	imes 	ext{Interest Burden} 	imes 	ext{EBIT Margin} 	imes 	ext{Asset Turnover} 	imes 	ext{Financial Leverage}$$

Question 18

Deferred Tax Liabilities (DTL) vs. Deferred Tax Assets (DTA)

Accepted Answer

- **Deferred Tax Liability (DTL)**: Created when $	ext{Financial Statement Income} > 	ext{Taxable Income}$. Represents taxes expected to be paid in future periods (e.g., using straight-line for accounting, accelerated for tax).
- **Deferred Tax Asset (DTA)**: Created when $	ext{Taxable Income} > 	ext{Financial Statement Income}$. Represents future tax savings (e.g., warranty reserves, loss carryforwards).
- **Valuation Allowance**: Contra-asset account under US GAAP reducing DTA if likelihood of realization is $<50\%$.

Question 19

Intangible Assets: Research vs. Development Costs

Accepted Answer

- **US GAAP**: Research and development costs are generally **expensed as incurred** (exceptions for software development costs after technological feasibility is reached).
- **IFRS**: Research costs are **expensed**. Development costs are **capitalized** once specific criteria are met (technical feasibility, intent/ability to complete and sell/use, probable future economic benefits).

Question 20

Free Cash Flow Metrics: FCFF and FCFE Formulas

Accepted Answer

- **Free Cash Flow to Firm (FCFF)**: Total cash available to all suppliers of capital.
$$	ext{FCFF} = 	ext{CFO} + 	ext{Interest} 	imes (1 - t) - 	ext{CapEx}$$

- **Free Cash Flow to Equity (FCFE)**: Cash available to common shareholders after debt obligations.
$$	ext{FCFE} = 	ext{CFO} - 	ext{CapEx} + 	ext{Net Borrowing}$$

CFA Level 1 - Financial Reporting & Analysis (FRA)

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