all review Flashcards
How are long-term assets initially recorded?
At cost, including purchase price, delivery, installation, and testing.
What are the two models for measuring PP&E under IFRS?
- Cost model: PP&E is recorded at cost minus accumulated depreciation & impairment.
- Revaluation model: PP&E is reported at fair value (less depreciation).
Which asset categories are amortized?
Finite-lived intangible assets (e.g., patents, licenses).
Which asset categories are tested for impairment but not amortized?
Indefinite-lived intangibles (e.g., goodwill, trademarks).
What is an impairment loss?
Occurs when an asset’s carrying value exceeds recoverable amount.
How is impairment tested under IFRS?
Compare carrying value with the higher of fair value less selling costs or value in use.
Can impairment losses be reversed?
- IFRS: Yes (except for goodwill).
- U.S. GAAP: No (except for held-for-sale assets).
What is the formula for depreciation using the straight-line method?
Depreciation Expense = (Cost - Salvage Value) / Useful Life
What is the effect of aggressive depreciation estimates?
Lower depreciation expense → Higher net income → Higher asset values.
How does impairment impact financial statements?
Lower assets, lower net income, lower equity.
What is a defined contribution plan?
Employer contributes a fixed amount, but employee bears investment risk.
What is a defined benefit plan?
Employer promises specific future payouts & bears investment risk.
How is a defined contribution plan recorded?
Expense = Employer’s contribution.
How is a defined benefit plan recorded?
Net pension liability or asset on the balance sheet.
What causes pension liabilities to increase?
- Lower discount rate
- Longer life expectancy
- Higher salaries
What is stock-based compensation?
Employees receive company stock as part of pay to align incentives.
How are stock options accounted for?
Fair value is estimated & expensed over the vesting period.
How does share-based compensation impact earnings per share (EPS)?
Increases outstanding shares → Lowers EPS.
What are performance shares?
Stock awards granted only if performance targets are met.
How do stock options impact financial statements?
No cash impact, increases equity, reduces net income.
What is a deferred tax liability (DTL)?
Taxes owed in the future due to temporary timing differences (e.g., accelerated depreciation).
What is a deferred tax asset (DTA)?
Future tax benefit due to deductible temporary differences (e.g., warranty expenses).
When do DTAs arise?
When taxable income is higher than accounting income today but will reverse in the future.
When do DTLs arise?
When accounting income is higher than taxable income today but will reverse later.
What happens if a DTA is unlikely to be used?
A valuation allowance reduces the DTA (U.S. GAAP).
How does an increase in the tax rate affect DTLs and DTAs?
- DTLs increase
- DTAs increase
What happens if a DTL is unlikely to reverse?
It may be reclassified as equity.
What is the formula for effective tax rate?
ETR = Tax Expense / Pretax Income
What does a high cash tax rate indicate?
Higher tax payments relative to reported earnings.
What is the impact of permanent tax differences?
They do not create DTAs or DTLs.
What is financial reporting quality?
Compliance with GAAP & decision usefulness.
What is earnings quality?
Sustainability & accuracy of earnings.
What are aggressive accounting techniques?
- Overstating revenue
- Underestimating expenses
- Delaying write-offs
What are conservative accounting techniques?
- Understating revenue
- Overstating expenses
What are signs of low-quality earnings?
- Large non-recurring items
- Frequent changes in estimates
- Overly smooth earnings
What is earnings smoothing?
Manipulating accruals to reduce earnings volatility.
How do analysts adjust for aggressive revenue recognition?
Compare cash flows to reported earnings.
What are signs of fraudulent financial reporting?
- Frequent restatements
- Unexplained CFO declines
- High reliance on non-GAAP measures
What are red flags in financial reporting?
Declining cash flows while profits rise.
What is the difference between GAAP compliance and high-quality reporting?
GAAP compliance does not ensure decision usefulness.
What is a pro forma financial model?
Forecasted income statement, balance sheet, and cash flows.
What is the first step in building a pro forma model?
Estimating future sales.
What factors influence revenue growth?
- Market size
- Industry trends
- Company market share
How do analysts forecast expenses?
Based on past trends & expected cost changes.
What is sensitivity analysis?
Testing model outcomes by changing key assumptions.
How does inflation impact financial modeling?
Affects cost structures and pricing decisions.
What is scenario analysis?
Creating multiple forecasts based on different assumptions.
What is the importance of working capital in forecasting?
Changes in working capital affect cash flows.
How does capital expenditure (CapEx) affect forecasts?
Higher CapEx → Lower free cash flow.
What are behavioral biases that affect forecasts?
- Overconfidence → Narrow confidence intervals
- Confirmation bias → Seeking only supportive evidence
- Anchoring → Relying too much on past estimates
What are the three main inventory valuation methods?
FIFO (First-In, First-Out), LIFO (Last-In, First-Out), Weighted Average Cost
Which inventory method results in the highest net income in inflationary periods?
FIFO
Which inventory method results in the lowest net income in inflationary periods?
LIFO
Which method results in the most up-to-date inventory balance?
FIFO
Which method results in the most recent costs being reflected in COGS?
LIFO
What is the impact of FIFO on financial statements during inflation?
- Higher net income (lower COGS)
- Higher taxes (higher profits)
- Higher inventory values (newer, costlier inventory remains)
What is the impact of LIFO on financial statements during inflation?
- Lower net income (higher COGS)
- Lower taxes (lower profits)
- Lower inventory values (older, cheaper inventory remains)
Why do some companies prefer LIFO?
Tax advantages (lower taxable income in inflation)
What is LIFO liquidation?
Occurs when old, lower-cost inventory is sold, artificially boosting profits
Why is LIFO not allowed under IFRS?
It does not reflect actual inventory flows and can distort earnings
What is an inventory write-down?
Reduction in inventory value due to obsolescence or market decline
How are inventory write-downs recorded?
- Expense on the income statement (increases COGS)
- Reduces inventory value on the balance sheet
When can inventory write-downs be reversed?
Under IFRS (if value recovers); Not allowed under U.S. GAAP
What financial ratios are affected by inventory write-downs?
- Lower gross profit margin (higher COGS)
- Lower net income (higher expenses)
- Lower inventory turnover ratio
- Lower current & total assets
What happens to financial statements if inventory write-downs are frequent?
Suggests poor inventory management
How does an inventory write-down affect cash flows?
No direct impact on CFO (non-cash charge)
How does an inventory write-down affect the balance sheet?
Lower inventory & lower total assets
What causes inventory write-downs?
- Obsolete inventory
- Lower market demand
- Damage or spoilage
What happens when inventory write-downs are reversed under IFRS?
Recognized as income, but cannot exceed original cost
How do analysts adjust for inventory write-downs?
Add back non-recurring write-downs for better comparability
Where are inventory disclosures found?
Footnotes of financial statements
What are key inventory disclosures?
- Valuation method used (FIFO, LIFO, Weighted Average)
- Total inventory value
- Inventory breakdown (raw materials, WIP, finished goods)
- Inventory write-downs & reversals
- Inventory pledged as collateral
Why do analysts look at changes in raw materials vs. finished goods?
- Rising raw materials → Expected demand growth
- Rising finished goods → Possible slowing demand
What does an increasing inventory turnover ratio indicate?
Faster inventory sales & better efficiency
What does a declining inventory turnover ratio indicate?
Excess inventory, possible obsolescence
How do inventory changes relate to sales trends?
Finished goods rising faster than sales → Declining demand
How can inventory ratios predict future earnings?
Excess inventory → Future write-down risk
What is the Days of Inventory on Hand (DOH) formula?
DOH = (365 / Inventory Turnover Ratio)
What inventory-related red flags do analysts watch for?
- Rising finished goods & declining sales
- Frequent large write-downs
- Significant changes in inventory methods
How do analysts adjust for LIFO vs. FIFO?
Use LIFO reserve to compare FIFO-based firms
What is the Inventory Turnover Ratio formula?
Inventory Turnover Ratio = COGS / Average Inventory
What is the Gross Profit Margin formula?
Gross Profit Margin = Gross Profit / Sales
What is the LIFO Reserve Adjustment formula?
FIFO Inventory = LIFO Inventory + LIFO Reserve
What is the Adjusted COGS (FIFO) formula?
Adjusted COGS (FIFO) = LIFO COGS – Change in LIFO Reserve
What is the importance of financial statement analysis for ethical investing?
Helps detect misstatements or manipulation
Ensures compliance with ethical standards in investment decisions
Ethical investing relies on accurate financial information to make responsible investment choices.
Which CFA standards relate to financial statement analysis?
- Standard I(C) Misrepresentation – Analysts must use accurate financial data
- Standard I(D) Misconduct – Prohibits fraudulent financial analysis
- Standard V(A) Diligence and Reasonable Basis – Requires thorough research
These standards guide analysts in maintaining integrity and transparency.
How does bias in financial analysis violate ethics?
Can lead to misleading investment recommendations
Bias can distort the objective evaluation of financial data.
Why is professional skepticism important in financial analysis?
Ensures financial statements are reviewed critically
Professional skepticism helps identify potential issues in financial reporting.
What role do regulators play in financial statement integrity?
Ensure financial statements adhere to accounting standards (GAAP/IFRS)
Regulators oversee compliance with established accounting principles.
Why is independence in financial analysis crucial?
Analysts must avoid conflicts of interest in reporting
Independence enhances the reliability of financial analysis.
What happens when an analyst relies on misleading financial statements?
Leads to poor investment decisions & potential ethical violations
Misleading statements can result in significant financial losses.
How should analysts address financial reporting concerns?
Disclose concerns in reports & question management
Transparency is key to maintaining ethical standards.
What is the risk of aggressive accounting?
Can inflate earnings & mislead investors
Aggressive accounting practices can create an unrealistic financial outlook.
How do auditors impact financial reporting quality?
Provide independent assurance of accuracy
Auditors play a critical role in validating financial statements.
What are the key factors in credit analysis?
- Profitability – Ability to generate income
- Liquidity – Ability to pay short-term obligations
- Solvency – Long-term financial stability
These factors are essential for assessing a company’s creditworthiness.
Which financial ratios are most relevant for credit analysis?
- Liquidity ratios: Current ratio, quick ratio
- Solvency ratios: Debt-to-equity, interest coverage
These ratios help evaluate a company’s ability to meet its financial obligations.
Why is cash flow analysis critical in credit assessment?
CFO must cover debt obligations for a company to remain solvent
Cash flow is a key indicator of financial health and credit risk.
What factors impact a company’s credit rating?
- Debt levels
- Interest coverage
- Ability to generate cash flow
These factors are assessed by rating agencies to determine creditworthiness.
What is a bond covenant?
A legal agreement that protects creditors by restricting certain actions
Bond covenants are designed to minimize risks for lenders.
Why do rating agencies evaluate a company’s financial statements?
To assess the probability of default
Financial statement analysis is crucial for determining credit risk.
What happens if a company violates a loan covenant?
Lenders can demand repayment or increase interest rates
Violations can lead to severe financial consequences for the borrower.
What is a Z-score?
A metric used to predict bankruptcy risk
The Z-score combines various financial ratios to assess default risk.
How do financial statement footnotes help in credit analysis?
Provide hidden risks like off-balance sheet liabilities
Footnotes can reveal critical information not found in the main financial statements.
What are key activity ratios?
- Inventory Turnover = COGS / Avg. Inventory
- Receivables Turnover = Revenue / Avg. Accounts Receivable
- Payables Turnover = Purchases / Avg. Accounts Payable
Activity ratios measure how efficiently a company uses its assets.
What do liquidity ratios measure?
Ability to meet short-term obligations
Liquidity ratios help assess a company’s financial health in the short term.
What are key liquidity ratios?
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Cash + A/R + Marketable Securities) / Current Liabilities
- Cash Ratio = Cash & Equivalents / Current Liabilities
These ratios provide insight into a company’s liquidity position.
What do solvency ratios measure?
Long-term financial stability
Solvency ratios assess a company’s ability to meet long-term obligations.
What are key solvency ratios?
- Debt-to-Equity = Total Debt / Total Equity
- Interest Coverage = EBIT / Interest Expense
- Financial Leverage = Total Assets / Total Equity
Solvency ratios are essential for evaluating financial risk.
What are key profitability ratios?
- Gross Margin = Gross Profit / Revenue
- Operating Margin = Operating Profit / Revenue
- Net Profit Margin = Net Income / Revenue
- ROE = Net Income / Avg. Shareholder Equity
Profitability ratios indicate how well a company generates profit relative to its revenue.
What are key valuation ratios?
- P/E Ratio = Market Price per Share / EPS
- P/B Ratio = Market Price per Share / Book Value per Share
Valuation ratios help investors assess a company’s market value relative to its earnings.
Why is DuPont analysis useful?
Breaks ROE into profitability, efficiency, and leverage components
DuPont analysis provides a detailed view of the factors driving return on equity.
Why do analysts compare industry averages?
To assess relative performance
Comparing against industry averages helps identify strengths and weaknesses.
What does a declining liquidity ratio indicate?
Possible financial distress
A declining liquidity ratio may signal that a company is struggling to meet its short-term obligations.
How do equity analysts use financial ratios?
To determine valuation & growth potential
Financial ratios are critical tools for equity valuation.
How do credit analysts use ratios?
To assess default risk
Ratios provide insights into a borrower’s ability to repay debt.
Which ratios are most important for equity investors?
- P/E
- P/B
- ROE
- Growth rates
These ratios help equity investors evaluate potential returns.
Which ratios are most important for creditors?
- Debt-to-equity
- Interest coverage
- Cash flow ratios
Creditors need to assess the risk of default effectively.
Why do analysts examine financial trends?
To predict future performance
Trends provide insights into a company’s trajectory over time.
What does a declining ROE signal?
Earnings growth is slowing or leverage is increasing
A declining ROE may indicate potential issues with profitability.
Why is industry benchmarking important?
Some industries naturally have higher/lower debt levels
Benchmarking provides context for evaluating financial metrics.
What does a high P/E ratio suggest?
The stock is expensive or expected to grow rapidly
A high P/E ratio may indicate market optimism about future earnings.
How does financial leverage affect profitability?
More debt amplifies both gains & losses
Financial leverage can significantly impact a company’s financial performance.
What does a high interest coverage ratio mean?
The firm easily covers its interest payments
A high interest coverage ratio indicates strong financial health.
What are the three sections of the cash flow statement?
Operating Activities (CFO), Investing Activities (CFI), Financing Activities (CFF)
What are examples of inflows in CFO?
- Cash collected from customers
- Interest received
- Dividends received
What are examples of outflows in CFO?
- Payments to suppliers
- Payments to employees
- Interest paid
- Taxes paid
What are examples of inflows in CFI?
- Selling PP&E
- Selling investments
- Collecting loan principal
What are examples of outflows in CFI?
- Buying PP&E
- Acquiring investments
- Lending money
What are examples of inflows in CFF?
- Issuing stock
- Issuing bonds
- Borrowing money
What are examples of outflows in CFF?
- Repaying debt
- Repurchasing stock
- Paying dividends
What are key differences in cash flow classifications between IFRS & GAAP?
- IFRS allows flexibility for interest & dividends received and paid
- GAAP has stricter classifications for cash flows
What are non-cash investing & financing activities?
Not included in the cash flow statement but disclosed in footnotes
What are examples of non-cash investing & financing activities?
- Converting debt to equity
- Acquiring assets through leasing
What is free cash flow (FCF)?
FCF = CFO – Capital Expenditures (CapEx)
Why is cash flow important for financial analysis?
Less prone to manipulation than earnings; indicates a company’s ability to fund operations & investments
What are common red flags in cash flow statements?
- CFO significantly lower than net income
- Large changes in working capital accounts
What are the two ways to present CFO?
Direct Method and Indirect Method
What is the key difference between direct & indirect methods?
Direct Method lists specific cash payments & receipts; Indirect Method adjusts net income for non-cash items
What are common adjustments in the indirect method?
- Add back non-cash expenses (e.g., depreciation)
- Adjust for working capital changes (e.g., A/R, inventory)
Why do most firms use the indirect method?
Easier & required under GAAP
How do you convert indirect CFO to direct CFO?
Use income statement + balance sheet changes in A/R, A/P, inventory
What are the advantages of the direct method?
Shows actual cash sources & uses; more transparency
What are the advantages of the indirect method?
Links net income to cash flow; easier to prepare
How do interest & taxes differ between the two methods?
- Direct: Reported as separate cash flows
- Indirect: Embedded in net income & adjusted separately
Which method is recommended by IFRS & GAAP?
Direct method preferred, but indirect allowed
What is the best way for analysts to assess CFO?
Look at both direct & indirect methods to get the full picture
What are the steps to convert indirect CFO to direct CFO?
- Start with net income
- Remove non-cash items
- Adjust for working capital changes
What is an example of converting indirect CFO to direct CFO?
Indirect CFO = $50,000 + $10,000 – $5,000 + $7,000 + $3,000 = $65,000
Why do companies adjust for working capital?
To reflect actual cash flows instead of just accrual-based earnings
Which working capital accounts affect CFO?
- Accounts receivable
- Inventory
- Accounts payable
What happens if depreciation increases?
CFO increases (non-cash expense is added back)
What happens if accounts payable decreases?
CFO decreases (more cash paid to suppliers)
How do analysts use direct vs. indirect methods?
- Direct: Shows where cash comes from & goes
- Indirect: Shows link between net income & cash flow
What is a common mistake in cash flow conversion?
Forgetting that increases in assets = cash outflow and increases in liabilities = cash inflow
Which method provides better insight for financial analysis?
Direct method, because it shows actual cash flows
How do cash flow adjustments affect valuation?
Strong CFO supports higher valuation; weak CFO raises red flags
What are intangible assets?
Non-monetary assets with no physical substance (e.g., patents, trademarks, goodwill).
How are intangible assets classified?
Identifiable and Unidentifiable
- Identifiable → Can be bought/sold separately (patents, copyrights).
- Unidentifiable → Cannot be separately acquired (goodwill).
How are purchased intangible assets recognized on the balance sheet?
Capitalized & amortized (finite life).
How are internally developed intangible assets recognized under U.S. GAAP?
Expensed, but IFRS allows capitalization during development.
What is the cost model for measuring intangible assets?
Report at historical cost – amortization – impairment.
What is the revaluation model in IFRS for intangible assets?
Report at fair value if an active market exists.
What is amortization?
Spreading the cost of finite-lived intangibles over time.
Are indefinite-lived intangibles amortized?
No, they are tested for impairment annually (e.g., goodwill).
How do U.S. GAAP and IFRS differ in R&D treatment?
Research: Expensed under both; Development: Expensed (U.S. GAAP), Capitalized if criteria met (IFRS).
What costs are always expensed under both IFRS & GAAP?
Start-up costs, training, admin costs, advertising, relocation.
What should analysts look for in intangible asset disclosures?
Amortization policies, impairment charges, R&D treatment.
How do intangible assets impact financial ratios?
Higher amortization → Lower net income, lower profitability ratios.
Expensed R&D → Lower assets, lower equity, lower ROE.
What is goodwill?
The excess purchase price over the fair value of acquired net assets.
How is goodwill created?
Only through acquisitions (not internally generated).
How is goodwill treated in financial reporting?
Not amortized, but tested for impairment annually.
What does an impairment of goodwill indicate?
That the acquired company’s expected future earnings have declined.
How does goodwill affect financial analysis?
Overstated goodwill can make assets appear higher than they should.
Impairment charges reduce net income, affecting earnings ratios.
Is negative goodwill possible?
Yes, when a company buys another firm below fair value → Reported as a gain.
How should analysts treat goodwill?
Some analysts remove goodwill from assets when calculating financial ratios.
How do IFRS & GAAP differ in goodwill accounting?
IFRS → Impairment charged immediately; U.S. GAAP → Can use a two-step impairment test.
What is economic goodwill vs. accounting goodwill?
Economic goodwill → Related to future earnings potential; Accounting goodwill → The amount recorded in financial statements.
What key ratios are affected by goodwill impairment?
ROA = Net Income / Total Assets → Lower if impairment occurs; ROE = Net Income / Equity → Can decline if goodwill is written down.
What are financial instruments?
Contracts that create financial assets & liabilities (e.g., bonds, stocks, derivatives).
How are financial instruments classified under U.S. GAAP?
Held-to-maturity, Trading securities, Available-for-sale
- Held-to-maturity → Amortized cost
- Trading securities → Fair value, gains/losses in income statement
- Available-for-sale → Fair value, gains/losses in OCI.
How does IFRS classify financial instruments?
Amortized cost, Fair value through OCI, Fair value through profit/loss.
How do unrealized gains/losses affect financial statements?
Trading securities → Income statement; Available-for-sale → Other comprehensive income (OCI).
Why do analysts adjust financial instruments?
To normalize earnings & assess true profitability.
What key ratios are affected by financial instrument classification?
Net income (if securities are classified as trading); Equity (if unrealized gains/losses bypass income statement).
What are derivatives & how are they reported?
Contracts based on an underlying asset’s value; Always reported at fair value.
How do financial instruments affect financial analysis?
Misclassification can distort income & balance sheet values.
What should analysts look for in financial instrument disclosures?
Classification choices, fair value changes, OCI adjustments.
How do financial instruments impact cash flows?
Trading securities impact CFO, while AFS securities impact CFI.
When is revenue recognized?
When earned & when seller transfers control of goods/services
Not necessarily when cash is received.
What are the steps in the 5-Step Revenue Recognition Model?
- Identify the contract with a customer
- Identify performance obligations in the contract
- Determine the transaction price
- Allocate the price to performance obligations
- Recognize revenue when/as obligations are satisfied
What are performance obligations?
Promises to transfer distinct goods/services
How are long-term contracts recognized?
Recognized over time (percentage of completion)
When are bill-and-hold sales recognized?
Recognized only when control transfers
How are franchise fees & licensing recognized?
Recognized over the contract period
Why do analysts care about revenue recognition policies?
Differences in timing & estimation affect comparability
What is aggressive revenue recognition?
Recognizing revenue too early, boosting short-term earnings
What is conservative revenue recognition?
Delaying recognition, making future periods look better
How do returns & allowances affect revenue?
Revenue is reported net of estimated returns & allowances
How does unearned revenue work?
Record unearned revenue (liability) if cash is received before performance
What are key revenue recognition risks?
- Channel stuffing
- Fictitious sales
- Holding the books open
How should analysts adjust revenue?
- Examine footnotes & disclosures for revenue policies
- Adjust for one-time revenue (e.g., asset sales, litigation settlements)
- Compare revenue growth to cash collections to detect manipulation
Why does revenue recognition affect financial analysis?
Impacts profitability ratios (e.g., gross margin, net margin)
How does earlier revenue recognition affect profitability?
Higher current profitability, lower future profits
How does delaying revenue affect earnings?
Smoother earnings, conservatism in accounting
What is the formula for Gross Margin?
Gross Margin = (Revenue – COGS) / Revenue
What is the formula for Net Profit Margin?
Net Profit Margin = Net Income / Revenue
What is the formula for Accounts Receivable Turnover?
Accounts Receivable Turnover = Revenue / Average A/R
What is the formula for Days Sales Outstanding (DSO)?
DSO = 365 / A/R Turnover
What are red flags for revenue manipulation?
- Revenue grows but cash collections lag (A/R rising)
- Unusual one-time sales boost earnings
- Significant revenue from new/unproven customers
What can happen if a firm manipulates revenue?
Can lead to earnings restatements & fraud investigations
How do IFRS and GAAP differ in revenue recognition?
IFRS allows more flexibility; U.S. GAAP has stricter rules
What is the impact of aggressive revenue recognition on valuation?
Can inflate valuation multiples
What does a large deferred revenue balance indicate?
Indicates future revenue growth
What could declining deferred revenue signal?
Could signal weak sales pipeline
How should analysts compare firms with different revenue recognition policies?
- Normalize ratios & margins to account for differences
- Use cash flow-based metrics (e.g., cash flow from operations)
Why are disclosures important for revenue recognition?
Help analysts identify revenue timing, key assumptions & risks
