CFA LEVEL1 - ACCOUNTING

ANALYSIS OF FINANCING LIABILITIES

Identify the effects of the financing method on the
statement, balance sheet, and cash flow statement.

income

Two basic principles

1. Debt equals present value of the future interest and principal payments. For
book values the discount rate is the rate when debt was incurred. For market
values the discount rate is the current rate.
2. Interest expense is the amount paid to the creditor in excess of the amount
received; though total to be paid is known, allocation to specific time periods
may be uncertain.
Current liabilities: (1) Operating and trade liability and (2) advances from
customers are the consequence of operating decisions, the result of normal
activity; (3) Short term (ST) debt and (4) current portion of long term (LT) debt
are the consequence of financing activity and indicate a need for cash or
refinancing. A shift from operating to financing indicates beginning of liquidity
problems, and inability to repay ST credit is a sign of financial distress.
Long term debt: May be obtained from many sources that may differ in
interest and principal payments, and claims creditors have on the firm's
specific or general assets; some claims are below or subordinated to others,
others' claims may be senior or have priority.
A bond is a contract between a borrower and a lender and obligates bondissuer (or the borrower) to make payments to the bond-holder (or the lender)
over the bond's life - (1) periodic interest and (2) repayment of principal at
maturity. Bond's face value is lump sum payment made at maturity; the
coupon rate is the stated cash interest rate.
Bond transactions:
1. Initial liability is listed in the Balance Sheet (B/S) and is amount paid to
issuer by lender.
2. Effective interest rate is the market rate and the interest expense is market
rate multiplied by the liability.
3. The coupon rate and face value are used to calculate actual cash flows only.
4. Liability over time is a function of (1) initial liability and the relationship of
(2) interest expense to (3) the actual cash payments.
5. Total interest expense is equal to amounts paid by the issuer to the creditor
in excess of the amount received.
Refer to White, Sondhi & Fried (WSF), Exhibit 8-1, pp565-6. which presents a
table showing transactions for bonds issued at par, premium and discount.
Financial Statement Effects (FSEs):
Refer to Exhibit 8-2, WSF, p569, which compares FSEs of bonds issued at per,
premium and discount.
Income statement (I/S) effects: The interest expense shown on the I/S is
effective interest on bond based on the market rate - effective at issuance
multiplied by the opening balance sheet (B/S) liability.
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Cash flow effects: Actual cash payments may not equal interest expense but
do equal the reduction in cash from operations (CFO), e.g., coupon payments.
Initial cash received and final face value payment are both treated as cash
from financing (CFF).
For bonds issued at premium (or discount) interest expense goes down (or up)
over time - this is a function of decreasing B/S liability; for each period,
interest expense is the product of the beginning liability and the effective
market interest rate.
Balance Sheet effects: At any point in time the liability on the B/S will equal
the present value of the remaining cash flow payments to the creditor
discounted at the effective market interest rate. The bond premium or
discount is amortized over the life of the bond by what is known as the
interest method - it results in a constant rate of interest over the life of the
bond. (N.B. Constant rate not a constant interest expense!)
Reported cash flows are identical across all three scenarios (see WSF Exhibit
8-3):
$100,000 face value payment treated as CFF, and $5000 (5000*6=$30K)
periodic cash payments are reported as reductions in CFO. For bonds issued at
a premium or discount, reported cash flows incorrectly describe the
economics of the bond transaction.
CFO will be understated for a premium bond because part of coupon payment
is a reduction of principal; CFF is overstated by an equal amount.
CFO will be overstated for a discount bond as part of the amortization of the
discount represents additional interest expense; CFF is understated by that
amount.
The cash flow classification of debt payments depends on the coupon rate, not
the effective interest rate.
Zero Coupon Bond (ZCB): has no periodic interest payments and is issued at a
discount from par. Repayment at maturity includes all the unpaid interest
expense (equal to face value minus the proceeds) from the time of issuance.
Refer to WSF, Exhibit 8-4, p571, which shows the IS, cash flow and BS effects
for a ZCB. Repayment of $100,000 includes about $25,000 of interest that
won't be reported as CFO; the full $100,000 payment will be treated as cash
from financing. Interest on a ZCB never reduces operating cash flow, and CFO
is overstated when a ZCB is issued, therefore, providing the cash needed to
repay bond may be a burden.
Variable rate debt: doesn't have a fixed coupon payment, so periodic interest
payment varies with the level of interest rates, exposing the interest expense
to uncertainty. If rates rise a firm's debt/equity ratio is unchanged but its net
income will fall because of the increased interest expense.
Debt with equity features:
Convertible debt: Convertibility feature is ignored when bond is issued, so the
entire proceeds of a bond are treated as a liability. When the stock price is
higher than conversion price treat it as equity - when converted into equity,
the proceeds are treated as equity (no longer debt or bond). When stock price
less than conversion price treat it as debt.

CFA L1 -ACCOUNT

Bonds with warrants: Proceeds divide between the two. Bond issued at a
discount and interest expense includes amortization of the discount. Warrant
is treated as equity with no income statement effects. When warrant is
exercised cash increases equity. Reported interest expense will be higher
when warrants are used than for convertibles (reported interest expense is
lower). CFO is same as only coupon interest is included.
Perpetual debt: Certain foreign debt has no maturity and should be treated as
(preferred) equity.
Preferred equity: have fixed dividend and priority over common shares in a
sale or liquidation. Dividend payments are cumulative - if not paid when due
they remain a liability, and are treated as interest. Preferred equity are
callable and redeemable and included as debt in solvency ratios.
Effects of interest rate changes: leads to changes in debt value but these are
not reflected in the financial statements.
Restructured debt: is restated to fair market value using market interest rate
and restructured cash flows.
Loan impairment: from a debtor may impact a financial firm but debt is not
restructured - should account for loan at present value using current market
interest rates.
Estimating market values: for publicly traded debt this is easy. For non
publicly traded debt find present value of future cash flows.
Market or book value for debt: Assumptions are required to calculate market
values. It is not worthwhile when debt is short maturity; or involves a variable
interest rate; or when there has been little change in the market interest
rates.
Retirement of bonds prior to maturity: may cause a difference in market and
book value, which is treated as an extraordinary gain or loss on the income
statement.
Callable bonds: Gains or losses on calling debt are ignored by the analyst
because the accounting treatment doesn't agree with the economic benefits.
Financial reporting by lessees: The present value of the minimum lease
payments is the amount at which the leased asset and obligations are initially
reported on the lessee's balance sheet. Refer to discussion in other LOS on
leases.
Discuss the accounting treatment of debt retirement.
Retirement of bonds prior to maturity may produce a difference between book
and market value and is treated as an extraordinary gain or loss in the I/S
under SFAS4. When a firm replaces a high income issue with another issue
when rates are lower, the firm will recognize a loss even though there will be
lower future interest expense. The amount and time of the accounting and
economic gain may be quite different.

CFA L1 -ACCOUNT

A Callable bond allows issuer to buy back the bond from holder at
predetermined date and price - usually at a premium over bond's face value.
Gains or losses on the calling of debt are typically ignored by the analyst
because the accounting treatment (i.e., loss on the I/S) does not agree with
the economic benefits.
Refer to WSF, Exhibit 8-7, p584 - Analysis of Callable bond.
Distinguish and discuss the differences between an operating and a
financial (capitalized) lease.
Operating leases (OL) allow the lessee to use the property for only a portion of
its economic life. OLs are accounted for as contracts. Lessee reports only the
required lease payments as they are made. There is no B/S recognition of the
property. For the lessor payments received are recognized as income, the
property remains on the B/S and is depreciated over time. Benefits of OL: (1)
Leasing asset avoids recognition of debt on lessee's BS; (2) OLs result in
higher profitability ratios and reduce reported leverage for lessees.
Capital leases (CL) involve effective transfer of all risk and benefits of property
to the lessee. CL are economically equivalent to sales, and are treated as
sales for accounting purposes. The asset and associated debt are reported on
the B/S of the lessee and the asset is depreciated over its life. Lease
payments are treated by lessee as payment of both principal and interest.
Benefits of CL: Lessors have earlier recognition of revenue and income by
reporting a completed sale though the substance of the transaction is similar
to installment sales or financing.
In an operating lease the lessee expenses the payments as they are made. In
a capital lease the value of the lease is booked to fixed assets and to long and
short term debt.
A lease meeting any of the following criteria at inception must be classified as
a capital lease by the lessee:
1. The lease transfers ownership of the property to the lessee at the end of
the term.
2. The lease contains a bargain purchase option.
3. The lease term exceeds 75% of the asset's life.
4. The PV of the minimum lease payments equals or is greater than 90% of
the asset's fair market value, using the lessee's incremental borrowing rate or
the implicit rate of the lease.
For the lessor, the lease must be capitalized if it meets:
1. Any of the four above conditions.
2. Collectability of the minimum lease payments is reasonably predictable.
3. There are no uncertainties regarding the amount of unreimbursable cost
yet to be incurred by the lessor.
Identify incentives for leasing.
When purchasing an asset the buyer acquires ownership of the asset and all
benefits and risks embodied in the asset. A firm may acquire use of the asset,
including some or all the benefits and risks for specified periods of time, by
making payments through contractual arrangement called a lease.
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CFA L1 -ACCOUNT

Other incentives:
1. Tax incentives.
2. Non-tax incentives:
2.1 Favours Operating lease: Period of use is short relative to overall life of
asset; Lessor has comparative advantage in reselling the asset; Corporate
bond covenants contain specific covenants relating to financial policies that
the firm must follow; Management compensation contracts contain provisions
expressing compensation as a function of returns on invested capital.
2.2 General incentives for leasing: Lessee ownership is closely held so that
risk reduction is important. Lessor has market power and can generate higher
profits by leasing the asset than selling it. Asset is not specialized to the firm.
Asset's value is not sensitive to use or abuse (as owner takes better care of
asset than lessee).
Calculate and explain the differences between income statement and
balance sheet accounts for financial and operating leases.
Lease classification: As mentioned above, if the lease is (1) a bargain, or (2)
transfers ownership at the end of the lease, or (3) the lease term is more than
75% of the asset's economic life, or (4) the PV of the minimum lease
payments (MLP) discounted at lessee's borrowing rate or rate implicit in the
lease of the lessor is equal to or greater than 90% of asset's fair market value
(FmV), then the lessee must capitalize the lease. If all of these four are not
met then lessee classifies it as an operating lease.
Lease capitalization: Refer to WSF, pp594-601 and Exhibits 8-12, A to E.
PV of MLPs is the amount at which leased asset and obligation are initially
reported on the lessee's Balance Sheet (B/S) (n=10; PMT=$100,000; FV=0;
i=9% therefore PV=$641,766).
A lease not meeting above four criteria is an OL as no purchase has occurred,
and no asset is reported in the financial statements. Rental lease payments
are reported as rental expense.
B/S effects: When a lease is a CL, gross ($641,766) and net amounts are
reported at each BS date. CL increases asset balances, resulting in lower asset
turnover and lower ROA, compared to OL classification.
The current liability is the principal portion of the first lease payment
(=$42,241). Non-current liability is the rest of the principal (=$599,525). At
lease's inception leased assets and liabilities (A&L) are equal at $641,766.
A most important effect of a CL is the impact on leverage ratios which result
in an increase in debt to equity and other leverage ratios. As lease obligations
aren't recognized for OL leverage ratios are understated.
Income statement (IS) effects: An OL charges constant rental payments to
expense as accrued, whereas a CL recognizes and apportions depreciation
and interest expense over the term of the lease.
Explain possible effects of leasing on taxes, net income, and cash
flow.
Refer to WSF, pp594-601 and Exhibits 8-12, A to E.
Operating income: Capitalization results in a higher EBIT as the straight line
depreciation expense of $64,177 is lower than the Operating Lease rental
expense of $100,000.
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Total expense & net income: CL interest expense falls over time and
depreciation expense is constant (straight-line depreciation) or declining
(accelerated depreciation method).
Total expense for CL declines over the lease term. Initially it's higher than OL
expense but over time it becomes lower.
Tax expense and net income for an OL are constant over time. Tax expense
and net income for a CL increase and for a CL one also reports an
accumulating deferred tax expense.
In general, compared to a CL, firms using an OL generally report higher
profits, interest coverage and ROA.
Lease expense (for CL=$121,936) exceeds lease payments (for OL=$100,000)
so there will be a deferred tax credit equal to 0.35*121,936-100,000 = $7678.
Deferred tax amount increases until lease expense is less than lease
payments, and then the account declines and is eliminated by the end of the
lease.
No deferred tax is reported for OL since the amount deductible for taxes and
reported lease expense are always the same. Total (interest and depreciation)
expense for CL must equal total rental expense on a OL, over the life of the
lease. Net income is not effected by CL but CL reports lower income earlier in
lease term and higher income later.
Cash flows: Under OL all cash flows are operating and there is an operating
cash outflow of $65,000 per year. Annual payments of $100,000 create a tax
benefit of $35,000 per year which is deductible regardless of lease method
used. CL produces operating cash flows (CFO) and financial cash flows (FCF).
The $100,000 paid under CL is allocated between interest and depreciation
expense. CFO is $22,759 which reflects interest payments and the tax benefit.
CFO differs between the two lease methods by $42,241, which is amortization
of the lease obligation (FCF for CL). For CL as interest expense declines over
lease and an increasing portion is allocated to the lease obligation, the
difference in CFO increases over the lease. CL therefore decreases operating
cash outflow while increasing financing cash outflow.
Summary: CL increases CFO (as only interest expense is deducted) and
decreases FCF.
Comparing CL to OL:
For CL, current ratio decreases; debt equity ratio increases and times interest
coverage ratio decreases.
For an OL, lease payments (-L) go to CFO. CL: Only interest portion (-I) goes to
CFO. Since -L > -I (negatively) CFO will be overstated in CL.
For an OL, no asset is reported; no liability recognized; leverage ratios are
unaffected; lease payments are expenses and fully deductible, so no deferred
taxes are required; all cash flows are operating cash flows.
Explain the balance sheet and income statement impact of a sale and
leaseback.
Sale-leaseback (S-L) transactions are sales of property by the owner who then
leases it back from the buyer-lessor. Recognition of profit/loss depends on how
much property use the seller/lessee retains - if all use of property is retained
by seller/lessee, transaction is considered a financing transaction and no profit
or loss should be recorded.
Use = PV of property's rents/fair value (FV) of assets sold and leased back.

CFA L1 -ACCOUNT

1. Minor leasebacks: PV/FV < 10% : Buyer has control of assets; any gain or
loss is recognized by seller at the inception of the sale leaseback.
2. More than minor but less than substantially all leasebacks:
PV/FV >10%<90% : Some of gain or loss must be deferred and amortized
over life of the lease.
3. Substantially all leasebacks: PV/FV => 90% : The leaseback is a financing
transaction and the gain or loss is recognized as the leased property is used the lessee must recognize the gain or loss on the sold and leased back
property.

ANALYSIS OF OFF-BALANCE-SHEET ACTIVITIES & HEDGING TRANSACTIONS

Identify the nature of off-balance-sheet (OBS) financing activities.
The emphasis on accounting assets and liabilities (A&L) rather than
recognition of economic resources and obligations limits the usefulness of
financial statements and encourages firms to keep resources and obligations
off the B/S.
Why pursue OBS financing? Historical cost B/Ss often underestimate the true
value of assets, understating the firm's equity. Since the B/S lists the cost but
not gain of assets there is little incentive to put assets on the BS in the first
place.
Explain the motivation for developing OBS sources.
There are three reasons why a firm may engage in OBS transactions:
1. Avoid reporting high debt and leverage ratios, and to reduce
probability of technical default under restrictive debt covenants;
2. Keep assets and potential gains off the financial statements but under
control of management;
3. To acquire these assets because they do contribute to the operations of
firm. Assets excluded from the financial statements do contribute to
operations of the firm.

the
the
the
the

(For a complete analysis the analyst must bring OBS A&L's back on to the BS.)
Describe examples of OBS financing transactions.
1. Accounts receivable: Legally separate and fully owned finance subsidiaries
have been used to purchase receivables from parents, which use the proceeds
to retire debt. Refer to WSF, Exhibit 10-2, p719. Consolidation of assets and
liabilities of controlled subsidiaries is required.
2. The sale of receivables to unrelated parties is simply collateralized
borrowing.
For 1 & 2, cash flows are distorted because cash is received earlier, but sale of
receivables has a beneficial impact on reported liquidity, turnover, leverage
and return ratios.
3. Inventories: Take-or-pay contracts ensure long term availability of raw
materials and other inputs for operations.
4. Throughput arrangements ensure required distribution or processing needs
for natural resource companies.
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CFA L1 -ACCOUNT

For 3 & 4, effect is to allow firms to acquire use of operating capacity without
showing associated A&Ls on the B/S.
5. Commodity linked bonds: Firms may finance purchases of inventory with
debt linked to some underlying commodity linked to inventory, to serve as a
natural hedge against changes in commodity and inventory prices.
6. Joint Ventures: Firms acquire operations via joint ventures with other firms,
and financing may involve direct or indirect guarantees of debt, which should
be evaluated for adjustments to the firms debt and other ratios.
7. Investment: A firm may hold stock in another firm, and also issue debt
which it can exchange for the shares in the other firm, which should lower
their borrowing cost, defer capital gains and give a tax break on dividends
from the shares. It still owns the investment and can use the cash.
Describe the accounting issues and disclosure requirements
associated with hedging
activities.
SFAS 105 & 107 state requirements for disclosures about financial
instruments. For those with OBS risks SFAS 105 requires disclosure of
contractual amount, nature and terms of instruments, description of collateral
and a discussion of their risk in the event of default by the counter party. SFAS
107 requires disclosure of market values for all financial instruments on and
off the B/S, and any assumption used to estimate fair values.
Calculate the income statement and cash flow effects of OBS
financing activities.
How to handle OBS borrowing through sale of receivables; footnote
disclosures reveal that the sale has not transferred the risk. Refer to the
example in WSF, Exhibit 10-2, p719.
1. Balance sheet: Reinstate the receivables. Increase the debt by the
receivables amount.
2. Income statement: Increase EBIT by the imputed interest on the sale.
Increase interest expense by the imputed interest on the sale.
3. Cash flow: Total cash flow hasn't changed but one must decrease cash flow
from operations by the receivables sold and increase cash flow from financing
by the same amount.
4. Financial ratios: Recalculate the firms financial ratios based on the revised
figures.
Schweser example
Balance sheet:
Debt
Equity
Debt/equity ratio

(p10-2): $170,000 of receivables sold

As reported
Adjusted
$1,300,000
$1,470,000
$580,000
$580,000
2.24
2.53

Assume 9% interest rate; interest expense=$15,300.

Income statement: As reported
Adjusted
EBIT
$265,000
$280,300
Interest expense $102,000
$117,300
Coverage ratio
2.60
2.39
Also need to decrease CFO and increase CFF by amount of receivables sold total cash flow is not effected.

CFA L1 -ACCOUNT

ANALYSIS OF CHANGING PRICES INFORMATION

Discuss advantages and disadvantages of using constant- and
current-cost accounting.
Constant dollar method:
Advantages: Simple to calculate; objective; verifiable; understandable; and
easy to prepare and audit.
Disadvantages: It has no apparent use - loss of purchasing power is a useful
concept but has limited use in financial world as markets transact in nominal
terms. Also it is general in that all firms are treated alike.
Current dollar method:
Advantages: It is theoretically correct in that it measures a firm's ability to
replace the resources during the period.
Disadvantages: It is complex, subjective, based on unreliable assumptions,
and difficult to prepare and audit.
Discuss problems directly related to adjusting financial statements
for changing prices and to the use of constant-dollar data.
The constant dollar method measures the firm's ability to maintain financial
capital while the current cost method measures the ability of the firm to
maintain its physical capital.
Adjusting financial statements (FSs) for changing prices.
Changing prices for fixed assets effect FSs:
1. Fixed assets are carried at cost and with changing prices the carrying
amount does not reflect the current cost of those assets - it results in the
assets and their net worth being understated.
2. Depreciation is based on asset carrying amount, so understatement of
assets results in understatement of depreciation expense, which results in
overstatement of earnings.
In
1.
2.
3.

periods of inflation, on a firm's financial statements generally:

Income will be overstated;
Assets and net worth will be understated; and
Depreciation will be understated.

1. Adjustments to fixed assets: may be required to reflect current cost; these

may be real, current, and statistical estimates of fixed assets on the balance
sheet.
2. Prepare a current cost balance sheets, which shows the analyst:
-Management's use of available resources
-The borrowing ability of the firm
-The security provided to creditors
-The liquidity value of the company
3. Once current cost is estimated, estimate depreciation on a current cost
basis to amortize current cost of fixed assets. The goal is to replace capacity
used up during the accounting period. Estimated depreciation is used to
adjust reported income to a current cost basis, which produces a better
measure of sustainable income. Also results in ratios more representative of
management performance (e.g. using current cost during inflation reduces
ROE as income is reduced and equity is increased).
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Use of constant dollar data.

Constant dollar data are useful to look at investment returns from investor's
perspective, and are not useful for financial analysis.
This method is also used in highly inflationary economies, especially when
their financial systems are indexed, but unless input and output prices are
fully indexed, the constant dollar method won't provide a satisfactory basis for
analysis.

ANALYSIS OF INVENTORIES
Identify, explain, distinguish between, and describe the financial
statement consequences of inventory valuation methods allowed
under U.S. generally accepted accounting principles.
Ending Inventory = Beginning Inventory + Purchases - Cost Of Goods Sold
EI = BI + P - COGS
1. FIFO: The cost of the first item
sold.
2. LIFO: The cost of the last item
sold.
3. Weighted Average Cost (WAC):
purchased to determine the cost of

bought is the cost used for the first item

bought is the cost used for the first item
Uses the weighted average cost of items
goods and the ending inventory.

Financial Statement (FS) effects:

1. On the Balance Sheet (B/S) the FIFO method is preferred as these values
closely resemble current cost and hence current economic value.
2. On the Income Statement (I/S):
The going concern assumption implies income should be measured in terms of
profits after providing for replacement for inventory.
GAAP is based on historical cost and not replacement cost.
LIFO allocates most recent prices to the cost of goods sold, therefore for the
income statement LIFO is the most informative method and provides better
measurement of current income.
IRS regulations require that the method of inventory accounting used for tax
purposes must also be used for financial reporting.
With an increase in prices LIFO is the best method from an accounting
perspective, but liquidity measures are misleading because of the
understatement of working capital.
The analyst must be aware that FIFO firms will show higher net income.
Table: LIFO vs FIFO - Effects on income,
cashflow and working capital
LIFO
FIFO
COGS
Higher
lower
TAX
Lower
highe
r
Net income
Lower
highe
r
Inventory balances Lower
highe
r
Working capital
Lower
highe
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Cash flow

Higher

r
lower

Comment on inventory accounting practices used in major non-U.S.

economies.
FIFO and WAC methods are the most common methods used worldwide.
LIFO use is mainly limited to companies in the US, due to tax benefits.
LIFO is allowed but rarely used in Japan, Germany and France. Japanese
standards don't require disclosure of LIFO reserves. WAC method is the most
widely used method in Germany.
FIFO is the financial reporting method of choice in Canada and Spain; LIFO is
allowed for financial reporting but not for tax purposes.
LIFO is not allowed in the UK for tax purposes.
Calculate the impact of changes in inventory valuation methods on
the value of inventory (on the balance sheet), cost of goods sold, and
income.
The CFA candidate should perform exercises in calculating changes in
inventory valuation.
Adjustments from LIFO to FIFO:
On B/S:
FIFO inventory = LIFO inventory + LIFO reserve
On I/S:
Change in COGS = Beginning LIFO reserve - ending LIFO
reserve
On I/S:
Change in net income = (-)(change in COGS)(1 - marginal
tax rate)
The last two impacts on the I/S assume that the LIFO reserve increased over
the period.
COGSfifo = (COGSlifo) - (Ending LIFO reserve - Beginning LIFO
reserve)

ANALYSIS OF LONG-LIVED ASSETS

Describe the choices involved in reporting for long-lived assets when
they are acquired, over their useful lives, and when their useful lives
are ended.
Reporting for long-lived assets when they are acquired
Capitalizing versus expensing assets is a management choice that effects
financial statements. Firms' assets can be evaluated by looking at (1)
profitability (ROA), (2) solvency, and (3) operating efficiency and leverage.
Firms that capitalize costs and depreciate them over time will (compared to
firms that expense costs) show:
-smoother reported income;
-have higher asset and equity balances;
-have lower profitability measures (e.g. ROA & ROE);
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-have lower debt/equity and debt/asset ratios and therefore appear more
solvent;
-have higher reported cashflows from operations (CFO); and
-have lower investing cash flows (ICF) (because costs that would have been
posted to expenses (CFO) were charged to assets [ICF]).
Analytic adjustments: An industry may report a high ROA because R&D costs
are expensed (and capitalised in Canada, UK and France). For analysts,
capitalizing R&D will increase assets and lower ROA and may increase net
profit.
Valuation implications: An expense outflow decreases wealth; if it generates
future cash flow it increases wealth - the difference between an asset and an
expense outflow is whether the outflow generates future benefits. Expenses
outflow benefits only the current period; asset outflow benefits future periods.
The market assesses advertising as short-lived (i.e. an expense) and R&D as
long-lived (i.e. should be capitalized).
Economic consequence: Borrowing capacity and bond covenants depend on
profitability and leverage ratios; these are effected by the decision to expense
or capitalize; the market also may react to the decision thereby also
influencing the stocks value.
SFAS34 requires capitalization of interest costs when borrowing is associated
with the construction of operating facilities for a companys own use. To adjust
FSs for analysis: Take the interest expense out of assets and put it in
expenses. This will lower income (EAT) and decrease the firms interest
coverage ratios (EBIT/I).
Intangible assets: Expensed: Developing patents and copyrights, and
establishing technological and economic feasibility of software. Capitalized:
Franchises and licenses; cost of brands and trademarks; and goodwill only
when purchased.
Industry issues: Regulated utilities have an economic incentive to capitalize as
many outflows as possible to increase their asset base. Under the full cost
method, used for oil and gas exploration, dry holes are capitalized (thus asset
values are larger, profits are recognized earlier and cash flows are less
volatile); under the successful efforts method all dry holes are expensed.
Reporting for long-lived assets over their useful lives
Principle of depreciation: Cash flows generated by assets cant be considered
income until provision is made for the assets replacement; depreciation
expense apportions some of the cash flow as a capital return for reinvestment
or asset replacement. One needs to allocate the cost of the asset over time
using the (1) sinking fund, (2) straight line (SLD), (3) sum-of-years digits
(SOYD), (4) double declining balance (DDB), (5) units of production, or (6)
composite, depreciation methods.
Impact of depreciation methods on FSs: Depreciation is an allocation of past
cash flows and therefore does not have an impact on the statement of cash
flows. In the earlier years, with higher depreciation expense, accelerated
depreciation (cf. straight line) methods tend to depress net income and
retained earnings and lead to lower profitability (i.e. ROE, ROA). At the end of
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an assets life the effect reverses: companies will have stable or rising capital
expenditures; the early year effect will dominate and the depreciation
expense on a total firm basis will be higher using accelerated depreciation
methods. When capital expenditure declines accelerated depreciation will
result in a lower depreciation expense because the later year effect on older
assets will dominate.
Shorter asset life and lower salvage value are conservative because they lead
to a higher computed depreciation expense - these interact with the
depreciation method to determine the expense - e.g. the use of SLD method
with a short depreciation life may result in a similar expense to that of an
accelerated depreciation method with a longer life. Conservative depreciation
methods will increase ROA by decreasing the denominator.
Reporting for long-lived assets at the end of their useful life
See the above two paragraphs for during and end of life reporting, and the
following.
Analysis of Fixed Asset Disclosures. Estimating the age of assets and their useful
lives (for a firm using SLD) calculate:
Relative age: Average age (%)=accumulated depreciation ($)/ending gross
investment ($)
Average depreciable life (years)=ending gross investment ($)/depreciation
expense ($)
Average age of fixed assets (years)=average age (%) x average depreciable
life (years)
Average age of fixed assets (years)=accumulated dep'n (years)/depreciation
expense ($)
Average age and average depreciable life are useful for comparative purposes
as (1) older assets might be less efficient and (2) it might also be possible to
detect patterns of asset replacements.
Impact on financial statements:
Tax: End of life depreciation is fixed; as an expense it reduces taxable income.
Use accelerated depreciation methods to pay less tax and produce higher
cash flows in the earlier years.
Inflation: For analysis, as the replacement cost of the asset is increasing over
time, historical cost depreciation is insignificant to replace the asset.
Because of rising prices, incomes and taxes are too high.
Change in depreciation method : A change in the depreciation method
only for newly acquired assets is not a change in the accounting principle,
and does not have a material impact on financial results, and no special
disclosure is required.
A change in the depreciation (e.g. a change to SLD) method retroactively to
all assets results in an increase in income in the year of the change and in
future years; it also gives this cumulative effect due to the retroactive nature
of the change. This is considered a change in accounting principle; the
cumulative effect must be reported separately and net of taxes.
A change in asset or salvage value (which results in an increase in
income) is not an accounting principle change but a change in accounting

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estimate (and not principle i.e. depreciation method) and the impact is only
on current and future (and not past) periods.
Whenever a change in depreciation method (principle) or lives (estimate) is
reported, the impact of the change on the current years earnings should be
analyzed.
Explain circumstances under which valuation impairment leads to
either a write-down or a write-up.
Impairment:
1. GAAP requires assets to be carried at acquisition cost less accumulated
depreciation.
2. The carry amount must be reduced when there is no expectation the
amount can be recovered from future operations.
3. Assets carried at more than the recoverable amounts are considered
impaired.
Financial statement impact of impairments:
The lack of reporting guidelines make it a difficult analytical problem: 1. Write
down has no future economic consequences and are due to changed market
conditions. 2. Restructuring indicates a major reorganization of the companys
operations.
FASB may require recognition of impairment when there is no evidence of a
lack of recoverability of the carrying amount, which may be determined by: a
decrease in the market value or use of assets; adverse change in the legal or
business climate; significant cost overruns; or forecast of a significant decline
in long term profitability of the asset.
Discuss the impact of special circumstances on the presentation of
financial statements.
What do special circumstances mean? It may mean either impairment (see
previous LOS) or inflation (see SS9 - Analysis of Changing Prices Information).
Calculate the impact of changes in depreciation methods on fixed
assets (on the balance sheet) and income.
Depreciation:
Sinking Fund Depreciation: If the asset generates a constant cash flow over
time then it should generate a constant rate of return over time, therefore
depreciation must increase each period.
SF Depreciation = Cash flow depreciation [per period] / (asset cost/value
[per period])
Straight Line Depreciation = (cost salvage value)/useful life or 1/n*(cost
salvage value).
If income is constant, SLD will cause the asset base to decline causing ROA to
increase over time. For assets whose benefit may decline over time, the
matching principle supports using and accelerated depreciation method.
Accelerated depreciation methods:
Sum Of Years Digits = (cost salvage value)(years remaining)/(sum of years).
Double Declining Balance = 2*(cost accumulated depreciation)/(assets life).
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With SOYD and DDB methods income and equity will be lower than SLD in the
earlier years of the assets life. In later years the situation will reverse and
income and book values will increase.
The Units of Production method bases depreciation on actual service usage:
UOP=depreciation [per period] = output [per period] x unit cost
N.B. The CFA candidate should perform exercises in SLD, SOYD and DDB
depreciation calculations.
---------------------------------------------------------------------------------------------------------------Q. State the basic relationship between inventory and the cost of goods sold.
A. EI = BI + P - COGS
Q. What does GAAP require when reporting inventory?
A. GAAP requires use of lower of cost or market value for investing.
Q. What is LIFO liquidation?
A. LIFO liquidation is a process that occurs when a firm's sales cause it to
liquidate or sell some of the pools of inventory representing the older lower
costs.
Exercises:
1. The CFA candidate should undertake LIFO and FIFO calculations in scenarios
of rising and falling prices.
2. The CFA candidate should perform LIFO to FIFO adjustments.
(This notes is downloaded from http://members.aol.com/phdezra/index.htm)

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