Level II Review, Financial Reporting and Analysis

Study session five in the Level II CFA Program curriculum begins a long journey through Financial Reporting & Analysis (readings 17-18). To say the topic is important to the designation could be the understatement of the century and unless you have some strong training in financial statements you will need to spend a lot of time on the material.
I will try to cover some of the basic ideas and point you in the right direction but there is no way we can cover these study sessions completely in a blog post. **Devote yourself to mastering FRA and it will pay off exponentially not only on the exam but also in your professional career!
If you do not have a solid understanding of the three financial statements, i.e. if you cannot build out a statement of cash flows from the other two using both indirect and direct methods, then you need to go back through the level 1 material. Understanding how the three statements are related and what each line item means is necessary to the FRA material here.
A big part of the curriculum is the affect different reporting methods (i.e. LIFO versus FIFO) have on the statements and ratios. I have listed some of these below. Instead of memorizing these lists, you really need to understand why the affects are higher or lower.  This will help your understanding of the statements and reporting.
Inventories: Implications for Financial Statements and Ratios
FIFO, LIFO and weighted-average are the important methods here and you must understand how they differ, how changing prices affect balance sheet values and how they affect the income statement.
Assuming inflation and stable or increasing quantities,
LIFO (compared to FIFO) results in:

  • Higher COGS, cash flows (due to lower taxes)
  • Higher inventory turnover and debt-to-equity
  • Lower gross profit, EBIT, taxes, net income and lower ending inventory
  • Lower net and gross margins and current ratio

* In an inflationary environment, ending inventory will be highest under FIFO and lowest under LIFO with weighted-average costing falling in between. Cost of Goods Sold will be highest under LIFO and lowest under FIFO with weighted-average costing falling in between.
Accounting changes to LIFO are applied prospectively, whereas changes from LIFO are applied retrospectively. Changes in inventory valuation methods are allowed only with justifiable reason and if the change results in more reliable and relevant information.
Long-lived Assets: Implications for Financial Statements and Ratios
The focus here is on capitalization versus expensing of assets and the affect of the decision on the balance sheet and income statement.
Capitalizing an asset (relative to expensing it) results in:

  • Higher total assets, shareholders equity, net income the first year, cash flow from operations, and interest coverage in the first year
  • Lower income variability, net income in subsequent years, cash flow from investing, debt ratios and debt-to-equity, and interest coverage in subsequent years

*Remember, land is not depreciated and intangible assets with indefinite lives are not amortized but tested for impairment.
The three depreciation methods are extremely important and you need to know how to calculate the expense charge. Understand how each will affect inventory and income ratios as well as assumptions/limitations for each.
Choosing a financial lease (relative to an operating lease) of an asset will result in:

  • Higher assets, liabilities, net income in later years, EBIT and cash flow from operations
  • Higher ROA, ROE in subsequent years, Debt-to-Assets and Debt-to-Equity
  • Lower net income in early years and cash flow from financing
  • Lower current ratio, working capital, asset turnover, fixed asset turnover, and ROE in early years
  • Total net income and cash flow will be the same under either method

Study session six in the Level II CFA Program curriculum covers intercorporate investments, share-based compensation and multinational operations. With these “core” topics in FRA, I would recommend reviewing the readings for a couple of weeks including doing practice problems. FRA and the material on equity investments are worth close to half of your total score for the CFA level 2 exam. Spend the time necessary to master them.
‘til next time, happy studyin’
Joseph Hogue, CFA

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