Level II Review, Financial Statement Analysis

Study session seven in the Level II CFA Program curriculum includes three readings (22-24) in earnings quality issues and financial ratio analysis.
The Lessons We Learn
This is a good reading to become a better analyst but not necessarily easily testable in a multiple choice format. It’s mostly conceptual and just a basic rundown of ideas.
The material on risks, what they are and how companies can deal with each, is probably the most important so make sure you can describe each from memory. Flash cards are a good way of drilling yourself on this type of list-material.
Types of Risk: interest rate, forex, accounts receivable, price of materials, and credit risk.
Understand the use of derivatives and hedging for risk management. This (risk management) is an important part of the Level III CFA Program curriculum so getting a good base here will save time next year.
Evaluating Financial Reporting Quality
This reading is all about understanding the incentives to manipulation of financial reporting and how to detect it. Understand the advantages and disadvantages of accrual accounting, the long-term and short-term incentives to statement manipulation and how each line item might be manipulated.
Sources of accounting discretion:

  • Revenue: provision for doubtful accounts, warranty provisions, returns and allowances, timing of service
  • Depreciation: estimation of useful lives, residual value, method choice (LIFO, FIFO, Average)
  • Choices related to goodwill and other non-current assets
  • Pension accounting: estimate of return on plan assets, discount rates, wage growth, employee turnover
  • Stock option expense estimates
  • Use of reserves and special purpose vehicles
  • Sales of receivables with recourse
  • Understand that management may have an incentive to understate revenues as well as overstate them during a period.

Mechanisms for accurate reporting include external and internal auditors, management certification, threat of litigation, regulators and general market scrutiny.
** The calculation of the accruals ratios is extremely important and easily testable. Make sure you understand both the balance sheet and cash flow basis and can perform the calculations on the exam.
Understand that cash flow-based accruals are preferred because it is less easily manipulated but that the treatment of interest payments may differ across companies.
Understanding the warning signs to each issue, along with any basic calculation, is probably your best bet to points on the exam.
Integration of Financial Statement Analysis Techniques
The reading is really just practice of everything you have seen elsewhere but is a good way to test your understanding of the material to this point. If you have gone through the curriculum wishing it was more practically-based, then this is your reading. While specific questions from the cases will not appear on the exam, you can use the case studies to test yourself on the topic.
My advice would be to read through the material quickly and work through the cases. If it comes relatively easy and you remember all of the concepts, then move on to the next reading. There really isn’t anything new here but you absolutely must understand the concepts and calculations.
Study session eight in the Level II CFA Program curriculum begins the reading on Corporate Finance. Much of the material is conceptual with a few important formulas.
‘til next time, happy studyin’
Joseph Hogue, CFA

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