Study session nine in the Level I CFA Program curriculum details financial reporting & analysis with four readings (29-32) covering inventories, long-lived assets, taxes and long-term liabilities.
The material revolves around the choices for inventory accounting (FIFO, LIFO, Weighted Average, and Specific ID). You absolutely must know the FIFO AND LIFO concepts as well as how the choice affects ratios and the income statement. You will need this going into the CFA level 2 exam so don’t ignore it.
FIFO expenses the first items purchased for cost of goods sold, which are usually cheaper given inflation. This will lead to higher earnings from the lower expense. Ending inventory, working capital, shareholders’ equity, earnings, current ratio, ROA, ROE and the profit margin are usually higher using FIFO accounting.
LIFO expenses newer inventory first so ending inventory will usually be lower in an environment of increasing prices. Understand what happens in an inventory liquidation and what it means for taxes, cash flow and earnings. After-tax cash flow, debt-to-equity, and asset turnover are usually higher under LIFO accounting.
Understand how to convert LIFO to FIFO statements. Add the ending LIFO reserve to inventory. Subtract the change in LIFO reserve from the COGS for FIFO cost of goods sold. Adjust the LIFO net profit by the change in LIFO reserve and the tax rate for the FIFO net profit.
A table with LIFO and FIFO across the top and all the relevant ratios/financial statement line items down the side makes it easier to see how the two methods can cause differences in your analysis. Rather than just writing higher or lower, understand why the effect happens (i.e. shareholders’ equity is usually higher with FIFO because earnings and inventories are higher).
Much of the reading revolves around the capitalizing/expensing debate. Understand the rules for capitalizing and how/why managers might want to bend them.
Understand how the financial statement accounts and ratios differ under capitalizing or expensing. Return on equity, ROA, profit margin, pretax cash from operations, earnings, and shareholders’ equity will be higher under capitalization. Cash from investing, asset turnover, and debt-to-equity will be higher under expensing.
Understand that, as an analyst, you may want to adjust the statements for capitalized interest by: add capitalized interest back to interest expense, reclassify capitalized interest from investing to operations on the cash flow statement, remove capitalized interest from depreciation expense.
Remember the difference and how to calculate the methods of depreciation: straight-line, accelerated, and units-of-production and be able to estimate the age of fixed assets.
Debt-to-equity and asset turnover will be higher under an accelerated method of depreciation while ROE, ROA, profit margin, shareholders’ equity, and earnings are higher under straight-line.
Understand the concepts and general rules behind intangible assets and impairment.
You will need to know the difference between accounting profit and taxable income and how to calculate deferred tax assets and liabilities. A deferred tax liability is taxes that will be paid in the future because the company reported lower taxable income than profits, while a DTA is taxes that will be saved in the future.
Understand the concept behind temporary and permanent differences. Tax-exempt interest, allowable tax credits and life insurance premiums are the usual examples for permanent differences.
Be able to determine the income tax expense under the liability method: Taxes payable + change in DTL – Changes in DTA net of valuation allowance.
You need to be able to work through the calculation for interest expense, coupon payment and the ending carrying value of a bond. It can be a pain at first isn’t too difficult once you understand what is happening.
The interest expense is just the ending carrying value times the market rate times ½ for semiannual bonds. Reduce this by the interest payment (face value * coupon rate*1/2) for the change in the liability. The prior ending carrying value plus the change in liability is your new carrying value.
Understand how a change in interest rates affects the market value of debt and economic gains. An increase in rates will decrease the value of debt and lead to an economic gain.
Remember the five main debt covenants: limitations on asset disposal, restrictions on debt issuance, limits on use of borrowed funds, collateral maintenance, and dividend restrictions.
Study session ten in the Level I CFA Program curriculum concludes the material on FSA with reporting quality and some applications.
‘til next time, happy studyin’
Joseph Hogue, CFA