Financial Reporting and Analysis

• Financial Reporting and Analysis is the 2nd heaviest weighted topic on the CFA Level I and makes up 20% of the exam.
• Altogether, FRA for CFA Level I is made up of four study sections and over 500 pages of material.
• FRA makes up 15-20% of the CFA Level II exam.
• One of the most important parts of the FRA section is gaining an understanding of which data points go into specific formulas.
• FRA gives candidates a foundational understanding of financial roles, asset managers, wealth managers, and investment bankers.

A key topic that weighs heaviest on Level I, Financial Reporting and Analysis is a foundational building block every candidate needs to prioritize. The content itself is long and difficult for many, making up 20% of the total materials on the CFA Level I exam.

Financial Reporting Standards help investors and creditors make informed decisions by offering principles for preparing financial reports and figuring out the types and amounts of information via financial statements.

A company runs down its inventory toward the end of the financial year. In an inflationary environment, if the company uses LIFO, this is likely to result in an:

1. Increase in net income.
2. Increase in financing cash flow.
3. Increase in operating cash flow.

Answer: A. Increase in net income. This is referred to as LIFO liquidation, and the company can increase income if it sells inventory recorded at a low historic cost. Cash flows will be affected only by the increase in tax, which will reduce operating cash flows.

Income statements give information on the financial performance of a company. Required elements that you’ll find include revenue, expenses, gross profit, net income, and operating profit, which is referred to sometimes as EBIT or Earnings Before Interest and Taxes.

Income Statements Practice Question

Which of the following is least likely another name for the income statement?

1. Statement of financial position
2. Statement of operations
3. Statement of earnings

Answer: A. Statement of financial position. Statement of financial position refers to the balance sheet.

Balance sheets show a company’s total assets and capital sources at a specific point in time. Three elements make up a balance sheet. Assets, Liabilities, and Equity. Together they make up the equation:Assets = Liabilities + Equity

Balance sheets are helpful when looking at a company’s ability to meet its operating liquidity needs, offer distributions to shareholders, and keep track of its debt.

Balance Sheets Practice Question

Noncontrolling interests are typically presented under which balance sheet element?

1. Assets
2. Liabilities
3. Equity

Answer: C. Equity. Noncontrolling interests (minority interests) are presented in the equity section on the balance sheet.

A cash flow statement is made up of three main pieces. Cash Flow Operations from the company’s day-to-day activities. Cash Flow from investing activities comes from the purchase and sale of assets that aren’t related to normal business activities. And Cash Flow from financing activities that comes from capital financing activities.There are plenty of ratios using information from a cash flow statement to figure out the financial health of a company including free cash flow to the firm and free cash flow to equity.

Cash Flow Statements Practice Question

A statement of cash flows most likely enhances the reliability of the:

1. Statement of changes in equity
2. Statement of financial position
3. Statement of comprehensive income

Answer: B. Statement of financial position. The statement of cash flows ultimately shows the change in cash during an accounting period. Cash is an asset. The beginning and ending balances of cash are shown on a company’s balance sheets for the previous and current years, and the bottom of the cash flow statement reconciles beginning cash with ending cash.

Ratio Analysis and Common-Size Analysis are two techniques to help understand a company’s financial data. Additionally, there are several categories of ratios used for performance analysis.

These include activity ratios, liquidity ratios, solvency ratios, profitability ratios, and valuation ratios. You’ll find examples of each on a formula sheet. Finally, the DuPont Analysis method of decomposing return on equity is a core part of this section and breaks down the ROE into component parts to analyze the drivers of returns.

Financial Analysis Techniques Practice Question

If a firm issues convertible debt securities and these convertible debt securities are exercised, the growth rate will most likely:

1. Increase
2. Decrease
3. Remain the same

Answer: B. Decrease. Growth rate = Retention ratio × Return on equity = (1 – Dividend payout ratio) × (Net income / Equity) = (1 – Dividend per share / Earnings per share) × Return on equity

If a firm issues convertible debt then it will dilute the EPS of the firm and reduce the retention ratio. Also, the return on equity will decrease as the number of common shares in equity will increase. Hence, the growth rate of the firm will decrease.

Inventories, along with the Cost of Goods Sold are two core pieces within a company’s financial statement. To get a better understanding of Inventories, you’ll need to become familiar with the four methods for valuing inventory as it relates to the cost of goods sold.They are Specific Identification, Weighted Average Cost, First-In-First-Out (FIFO), and Last-In-First-Out (LIFO).

The reading also covers financial statement effects of a change in inventory valuation method, the measurement and reporting of inventory when its value changes, the presentation of inventories on the financial statements, related disclosures, and much more.

Inventories Practice Question

Relative to other industry players, which of the following BEST describes a firm reporting high sales growth and high inventory turnover?

1. The firm has obsolete inventory
2. The firm incurs lost sales by not carrying insufficient inventory
3. The firm is efficient in managing its inventory

Answer: C. The firm is efficient in managing its inventory. Relative to the industry, high sales growth, coupled with high inventory turnover, suggests greater efficiency in inventory management.

Long-lived assets are resources that are expected to provide benefits to a company for more than one year. They may be tangible, intangible, or financial assets.The reading includes a description and illustration of accounting for the acquisition of long-lived assets, the allocation of costs of long-lived assets over their useful lives, and the revaluation model based on the fair value of an asset. It also covers the concepts of impairment, accounting for the derecognition of long-lived assets, and financial presentation, disclosure, and analysis of long-lived assets.

Long-lived Assets Practice Question

Which of the following costs related to the requisition of a long-lived asset must generally be expensed in the United States?

1. Installation costs
2. Freight and delivery costs
3. Related research and development costs

Answer: C. Related research and development costs. Research and development costs in the United States should be treated as an expense when they occur (except for certain software development costs).

The Income Taxes reading takes a look at Deferred Tax Assets and Deferred Tax Liability. Deferred Tax Assets crop up when a company’s taxable income is greater than its accounting profit. And Deferred Tax Liability is what occurs when the opposite occurs and a tax deficit is created.The reading also covers types of timing differences between the recognition of taxable and accounting profit, unused tax losses and tax credits, the recognition and measurement of current and deferred tax, and the disclosure and presentation of income tax information on companies’ financial statements.

Income Taxes Practice Question

Deferred tax liabilities that are unexpected to be reversed in the future shall be:

1. Recognized as liabilities
2. Recognized as equity
3. Not recognized in the financial statements

Answer: B. Recognized as equity.

Non-current Liabilities are a likely sacrifice of economic benefits in periods greater than one year. The most common include bonds payable, leases, pension liabilities, and deferred tax liabilities.The reading introduces bonds and discusses the recording of interest expenses and interest payments. It also dives into fair value accounting for bonds, looks at the repayment of principal when bonds are redeemed or reach maturity, and provides an overview of debt covenants and disclosures about debt financing.

Non-current (Long-term) Liabilities Practice Question

If a company using US generally accepted accounting principles (GAAP) issues a zero-coupon bond, an analyst should:

1. Reduce cash flow from operations
2. Increase cash flow from investing
3. Increase cash flow from operations

Answer: A. Reduce cash flow from operations. Cash flow from operations is overstated since the full repayment of maturity value is treated as a financing cash flow whereas it represents interest repayments, which should be classified as an operating cash flow.

Financial Reporting Quality is an important skill for analysts and investors. Those who are able to recognize poor financial reporting quality before deficiencies are known are more likely to make profitable investment decisions to reduce losses. The reading looks closely at reporting quality and the interrelated attribute of results quality.

Financial Reporting Quality Practice Question

The information provided by a high-quality financial report will most likely:

1. Increase company value
2. Indicate earnings are sustainable
3. Faithfully represent the economic reality of the company

Answer: faithfully represent the economic reality of the company. High-quality financial reports provide decision-useful information that faithfully represents the economic reality of the company. Low-quality financial reports impede assessment of earnings quality.

Financial reporting quality relates to the quality of the information contained in financial reports whereas earnings quality pertains to the earnings and cash generated by the company’s actual economic activities and the resulting financial condition. High quality earnings are sustainable and increase company value.

Learning how to apply Financial Statement Analysis to real-world situations is the focus of this reading. Some valuable items the reading discusses include unpacking the key questions to address in evaluating a company’s past financial performance, how an analyst should approach forecasting a company’s future net income and cash flow, and how financial statement analysis can be used to evaluate the credit quality of a fixed-income investment.Additionally, the reading addresses how financial statement analysis can be used to screen for potential equity investments and how differences in accounting methods affect financial ratio comparisons between companies.

Financial Statement Analysis: Applications Practice Question

Which of the following companies is most likely to have low credit risk?

1. Small start-up companies
2. Companies with high free cash flow to total debt ratios
3. Companies that have a low return on their assets

Answer: B. Companies with high free cash flow to total debt ratios. Small start-up companies and companies that earn a lower return on their assets have higher credit risk as compared to those that have a high free cash flow to total debt ratio.

The CFA Level II exam builds on what you’ve learned during your study of Level I, and the Financial Reporting and Analysis section is no different. You’ll notice a format change from straight multiple-choice questions to multiple-choice questions presented in mini-cases called item sets. FRA represents a large 15-20% of the exam material, so you’ll need to have a solid study plan in place in order to dominate on exam day.

Intercorporate Investments are investments in the debt and equity securities of a different company. Companies utilize intercorporate investment to enter new markets, increase profitability, deploy excess cash, diversify their asset base, and gain a competitive advantage.

Intercorporate Investment Practice Question

Which of the following statements regarding the equity method is most accurate?

1. Both IFRS and US GAAP prohibit the reversal of impairment losses if the fair value subsequently increases
2. IFRS prohibits the reversal of impairment losses if the fair value subsequently increases, but under US GAAP such reversals are allowed
3. US GAAP prohibits the reversal of impairment losses if the fair value subsequently increases, but under IFRS such reversals are allowed

Answer: A. Both IFRS and US GAAP prohibit the reversal of impairment losses if the fair value subsequently increases. IFRS and U.S. GAAP are unanimous in that, under the equity method, the reversal of impairment losses if the fair value subsequently increases is not allowed.

A company is able to offer different types of benefits when an employee retires. Pension plans, health care plans, medical insurance, and life insurance are some examples. In order to estimate future benefits, companies often make certain assumptions that introduce complexity and can have a big impact on how the company reports performance and its financial position.

Employee Compensation: Post-Employment and Shared-Based Practice Question

If a company that follows US GAAP uses a higher expected long-term return on plan assets assumption, its year-end pension obligation will most likely be:

1. The same
2. Lower
3. Higher

Answer: A. The same. The expected long-term return on assets assumption has no impact on the pension obligation.

If a firm or business has operations located in a country other than its home country, it is considered a multinational corporation. That business can engage in transactions that are denominated in foreign currency or invest in foreign subsidiaries that keep their financial records in a foreign currency.This reading provides an overview of the accounting for foreign currency transactions and the translation of foreign currency financial statements. It also covers the specific rules embodied in International Financial Reporting Standards (IFRS) and US GAAP through examples.

Multinational Operations Practice Question

Which one of the following risks does a company bear when making a purchase in a foreign currency when payment is deferred?

1. The value of the foreign currency goes down
2. The value of the foreign currency goes up
3. The value of the domestic currency rises

Answer: B. The value of the foreign currency goes up. When a company defers payments on an item purchased with foreign currency, it bears the risk that the price of that currency goes up in value and it has to spend more domestic currency to make the purchase.

Financial Institutions are an intermediary between providers and recipients of capital or debt. Types of financial institutions include banks, investment banks, clearinghouses, credit card companies, brokers, dealers, investment managers, insurance companies, and more.This reading focuses on banks and insurance companies with information on what makes financial institutions different from other types of companies, how to analyze a bank, and how to analyze insurance companies.

Analysis of Financial Institutions Practice Question

Which of the following is a banking-specific analytical consideration that is not addressed by the CAMELS bank rating approach?

1. Capital adequacy
2. Government support
3. Competitive environment

Answer: B. Government support. Government support is one of the banking-specific analytical considerations that is not addressed by the CAMELS approach.

There are two perspectives that are vital when evaluating the quality of financial reports. Reporting quality and earnings quality. Reporting quality deals with the information disclosed in financial reports, while earnings quality reflects a satisfactory level of return on investment and sustainable future earnings.Additionally, the reading covers a conceptual framework for financial reporting quality, a discussion of how to evaluate financial reporting quality, and a focus on the quality of reported earnings, cash flows, and balance sheets.

Evaluating Quality of Financial Reports Practice Question

Understated contingent liabilities will most likely result in:

1. Understated income
2. Overstated expenses
3. Overstated owners’ equity

Answer: C. Overstated owners’ equity. Contingent liabilities reflect uncertain future expenses. Failing to record such a liability understates expenses (e.g., the negative outcome of a lawsuit), and consequently overstates current income. Overstating current income results in overstated owners’ equity.

The main reason for financial analysis is to help when making economic decisions. This is important before deciding whether or not to lend to a long-term borrower or invest in a common stock or venture capital vehicle. A financial decision-maker needs financial analysis to identify and make more visible potential outcomes rather than leave outcomes to chance. The reading offers examples of effective use of financial analysis in decision-making.

Integration of Financial Statement Analysis Techniques Practice Question

An analyst looking at the creditworthiness of a company would most likely concentrate on:

1. Interest coverage ratios
2. Cash flow from investing
3. The total of the short- and long-term debt

Answer: A. Interest coverage ratios. The ability of a company to cover its interest expenses is more important than the amount of cash flow from investing and the total amount of debt. Interest coverage gives a quick idea of whether or not a company can pay the minimum amount due on its debt now; without that ability, it will go under.

Financial Reporting and Analysis is a major focus of the first two CFA exams. This means you’ll need to prioritize it and understand how to best prepare for it as you map out your study plan. The FRA material is long and tedious for many CFA candidates with plenty of principles to memorize and concepts to master. Be sure to partner with UWorld for all your study needs as you take on this vital component of the CFA Program.

Practice Makes Perfect When It Comes to Your FRA Plan

Practice is the key to every successful study plan, and your FRA plan is no different. Prioritize practice questions to cement your understanding of the content and focus on the end-of-chapter questions to ensure you’re ready and confident. And keep time management at the forefront, a skill that can be enhanced with regular drilling to make sure you’re able to get to all the content.

Don’t Sleep on IFRS and GAAP Questions

Your FRA study plan should be laser-focused on IFRS and GAAP questions. These show up on the CFA exam often, so be sure to note the differences and similarities between the two. Having a clear understanding of these accounting methods can make a big difference on exam day.

Create A 3-statement Financial Model

The balance sheet, income statement, and cash flow statement are the keys to understanding FRA. Building a 3-statement financial model can help you get there. Just pick a company, download their financial reports, and use a financial modeling book to help you along the way.

Learn how to build an effective CFA study plan to help you pass each level of the CFA Program exam on the first try.