Fraternity Review

Level 1 Accounting Review
General Framework for the Financial Reporting and Analysis for the CFA Exam
Income Statement
Revenue
- COGS
This page was use to link the
accounting choices management
can make and how they affect the
vaious lines on a typical income
statement.
= Gross Profit
- Depreciation Expense
- Operating Expenses
= EBIT
Starting on the top line with the

revenue recognition methods,
followed by the inventory costing
methods, depreciation methods,
capitalizing vs. expensing costs,
interest capitalizing and dividend
payouts at the bottom.
- Interest Expense
= EBT
- Taxes
= Net Income
- Preferred Dividends
= EACS
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Exam Preparation & Investment Sales Training
Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

1
Email: info@examsuccess.ca
Accounting for Leases

In general, companies have two choices when it comes to the accounting for leases:
1) Operating lease
2) Finance (or Capitalized) lease
Finance Lease Accounting by the Lessee
Balance Sheet:
The initial value of both the leased asset and lease liability is the lower of the present value of
the future lease payments or the fair value of the leased asset.
Income Statement:
Reported lease expense is comprised of interest expense and depreciation expense
Cash Flow Statement:
The interest expense is recorded as an operating cash outflow
The repayment of the debt principal is recorded as a financing cash outflow
Operating Lease Accounting by the Lessee

Balance Sheet:
No asset or liability are recorded
Income Statement:
Reported lease expense is equal to the annual lease payment
Cash Flow Statement:
The annual payment is recorded as an operating cash outflow
Companies tend to prefer the operating lease structure because it results in the most favorable
ratios (as compared to finance (or capitalized) lease.
Finance Lease Account by Lessor

IFRS:
Company reports a receivable equal to the present value of the lease payments
Leased asset is derecognized
Lease payment is treated like a repayment of principal reducing the receivable and is recorded
as finance income
US GAAP:
Direct finance lease (PV PMTs = CV) and Sales type lease (PV PMTs > CV)
Operating Lease Accounting by Lessor

Record the asset on the Balance Sheet and report lease revenue and depreciation expense on the
Income Statement
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2
You should know the following quick comparisons:

When the analyst makes the adjustments from operating lease to finance lease, the following
results occur on the Balance Sheet of the company that has leased the asset:
Current Assets
Fixed Assets
Current Liabilities (Short-term Debt)
Long-term Debt
Equity
Finance (or Capitalized) Lease

Same
Higher
Higher
Higher
Same
Operating Lease
Same
Lower
Lower
Lower
Same
Right away you should know the current ratio (CA/CL) will fall and the debt to equity ratio
(D/E) will rise.
When the analyst makes the adjustment from operating lease to finance lease, the following
results occur on the Income Statement of the company that has leased the asset:
Sales
Cost of Goods sold
Gross Profit
Operating Expenses
Operating Income (EBIT)
Depreciation Expense
Interest Expense
Total Reported Lease Expense
(Current)
Total Reported Lease Expense (Future)
Net Income (Current)
Net Income (Future)
Finance (or Capitalized) Lease

Same
Same
Same
Lower
Higher
Higher
Higher
Higher
Operating Lease
Same
Same
Same
Higher
Lower
Lower
Lower
Lower
Lower
Lower
Higher
Higher
Higher
Lower
Right away you should know the operating profit margin (EBIT/Sales) rises, the net profit
margin (NI/Sales) falls and the interest coverage ratio (EBIT/Interest) falls.
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3
Accounting for Leases Learning Example:

The following data was taken from the 2013 annual report of Dover Corporation. (all data in $
millions)
Leased Assets
Following year 1
Following year 2
Table 1
Acquisition Cost
460
Net Book Value

170
Table 2
Finance Lease Liabilities
Minimum
Interest
Lease Payments Portion
18
3
25
5
Leasing
Liability
10
15
Table 3
Operating Lease Commitments
Nominal Value of the
Future Minimum Payments
Less than 1 year
150
1 3 years
270
Over 3 years
300
Based on the information given in Tables 1 to 3, answer the following:

1.
What is the total amount of finance lease liabilities that Dover would report on its
Balance Sheet at the end of fiscal 2013?
2.
Calculate the amount Dover will payout in finance lease commitments in fiscal year
2015.
3.
What amount of interest expense will Dover report in fiscal year 2014 based on its
finance lease agreements?
4.
Calculate Dovers total operating lease commitments as of the end of fiscal 2013.
5.
What is the minimum amount of rent expense Dover would report in fiscal year 2014
that is related to its operating lease agreements?
6.
What would the carrying amount of leased assets be at the end of fiscal year 2013?
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Answers:
1.
This is equal to the sum of the leasing liabilities reported in Table 2 Finance Lease
Liabilities. 10 + 15 = $25 million
2.
This would be found by looking at the Minimum Lease Payments row following year 2,
in Table 2, which is $25 million.
3.
This would be found by looking at the Interest Portion row following year 1, in Table 2,
which is $3 million.
4.
This is equal to the sum of the Nominal Value of the Future Minimum Payments, in
Table 3, which is 150 + 270 + 300 = $720 million.
5.
This is equal to the Nominal Value of the Future Minimum Payments found in Table 3,
row 1, Less than 1 year, which is $150 million.
6.
This is the Net Book Value of the leased assets found in Table 1and it is equal to $170
million.
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20.
A capital lease requires annual lease payments of $2,000 at the start of each year. Fair
value of the leased equipment at inception of the lease is $10,000 and the implicit
interest rate is 12 percent. If the present value of the lease payments equals the fair
value of the equipment at the inception of the lease, the interest expense (in $) recorded
by the lessee in the second year of the lease is closest to:
A.
B.
C.
960.
1,104.
1,200.
Solution according to the sample exam:

20.A The trick here is realize that the payments are made at the start of the year, so the first
payment does not include any interest! The $2,000 payment reduces the outstanding
debt to $8,000 and the interest expense for year 2 will be 12% x $8,000 = $960.
Correct solution:
Yes the first payment reduces the outstanding debt balance right away. The second payment
can be broken up between principal and interest, with the interest calculated as 12% x $8,000 =
$960. This $960 is the interest that has built up over the first year!
Year
Interest
Principal
Repayment
Debt at
Beginning of the
Year
$10,000
$0
$2,000
Debt at the
End of the
Year
$8,000
$8,000
$960
$1,040
$6,960
$6,960
$835.20
$1,164.80
$5,795.20
$5,795.20
$695.42
$1,304.58
$4,490.62
$4,490.62
$538.87
$1,461.13
$3,029.49
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Income Taxes
Accounting profit based on income statement results, follows accounting standards
Taxable income based on tax laws
Income tax expense reported on the income statement
Income tax payable reported on the tax return
Deferred tax assets occur when taxable income is greater than accounting profit
Valuation allowance reserve created against deferred tax assets, based on the probability of
realizing the deferred tax assets in the future. At B/S date if any doubt in recovery, reduce
DTA and increase VA and record a loss on the I/S.
Example:
The following information was taken from the annual report of Xerex Corp.
2012
15,000
800
Deferred Tax Assets

Valuation Allowance
2013
20,000
500
How would an analyst most likely interpret the change in the valuation allowance?
A.
B.
C.
there was an increase in the likelihood of realizing the deferred tax assets
there was a decrease in the likelihood of realizing the deferred tax assets
there was a decrease in the deferred tax liabilities
Deferred tax liabilities occur when taxable income is less than accounting profit
Tax base is the value of the asset or liability for tax purposes
Carrying value is the value of the asset or liability reported on the balance sheet
What could cause deferred taxes?

Development costs (capitalized):
Research costs (expensed):
A/R (doubtful accounts):
Advances from Customers (liab):
Tax Base < Carrying Value => DTL

Tax Base > Carrying Value => DTA
Tax Base < Carrying Value => DTL
Tax Base < Carrying Value => DTA
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7
Accounting for Bond Amortization, Interest Expense and Interest Payments

Effective Interest Rate Method Learning Example:
Jones Corp. issues a 7%, 3 year annual pay bond with a face value of $100,000 when market
rates are 5%.
Based on this information, calculate the following:
Year 1:
1. Carrying Value at the Beginning of the Year
2. Interest Expense
3. Interest Payment
4. Amortization of the Premium
5. Carrying Value at the End of the Year
Year 2:
2. Interest Expense
3. Interest Payment
Year 3:
2. Interest Expense
3. Interest Payment
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Solution:
Year 1:
1. Carrying Value at the Beginning of the Year:
FV = $100,000, I = 5, N = 3, PMT = $7,000
Compute PV = $105,446.50 (reported as a liability on the Balance Sheet)
2. Interest Expense = (Beginning Liability) x (Effective Rate)
= 105,446.50 x 5% = $5,272.32 (reported as interest expense on the Income Statement)
3. Interest Payment : is equal to the coupon payment
= $100,000 x 7% = $7,000 (reported on the Cash Flow Statement)
4. Amortization of the Premium = Interest Expense Interest Payment
= $5,272.32 - $7,000 = (1,727.68)
5. Carrying Value at the End of the Year;
= $105,446.50 $1,727.68 = $103,718.82 (reported on the B/S)
Year 2:
103,718.82
2. Interest Expense = 103,718.82 x 5% =
5,185.94
3. Interest Payment
7,000.00
(1,814.06)
5. Carrying Value at the End of the Year 103,718.82 1,814.06 = 101,904.76
Year 3:
1. Carrying Value at the Beginning of the Year 101,904.76
2. Interest Expense 101,904.76 x 5% =
5,095.24
3. Interest Payment
7,000.00
(1,904.76)
5. Carrying Value at the End of the Year 101,904.76 1,904.76 = 100,000
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Statement of Cash Flows Learning Exercise:

The following information was taken from the financial statements of Longhorn Corp. a
company that reports according to U.S. GAAP.
Balance Sheet
Cash
Accounts receivable
Prepaid insurance
Inventory
Fixed assets
Accumulated Depreciation
Total assets
2013
$ 4,000
25,000
5,000
37,000
316,000
(45,000)
342,000
2012
$ 14,000
32,500
7,000
34,000
270,000
(30,000)
327,500
Accounts payable
Salaries payable
Note payable
Capital stock
Retained earnings
Total Liabilities & Equity
$18,000
4,000
173,000
88,000
59,000
342,000
$16,000
7,000
160,000
84,000
60,500
327,500
Income Statement
Sales
Cost of goods sold
Depreciation expense
Insurance expense
Salaries Expense
Net Income
2013
$200,000
(123,000)
(15,000)
(11,000)
(50,000)
1,000
Based on this information, answer the following questions:

1.
The cash collections from customers is
2.
The cash paid to suppliers is
3.
The cash paid to employees is
4.
The dividends paid were
5.
Adjust the net income to compute operating cash flow
6.
Calculate the operating cash flow using the direct method
7.
Calculate the cash flows from investing activities
8.
Calculate the cash flows from financing activities
ExamSuccess.ca 2013

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Solutions:
1.
Cash received from customers = Sales +/- A/R
= 200,000 + (32,500 25,000) = 207,500
2.
Cash paid to suppliers = COGS +/- Inventory +/- A/P

= 123,000 + (37,000 34,000) (18,000 16,000) = 124,000
3.
Cash paid to employees = Salaries expense +/- Salaries Payable

= 50,000 + (7,000 4,000) = 53,000
4.
Dividends paid = Net Income - Retained Earnings

= 1,000 (59,000 60,500) = 2,500
5.
This question is really asking us to use the indirect method to calculate operating cash
flow:
Cash Flow from Operations:
Net Income
Depreciation Expense
Accounts receivable
Prepaid insurance
Inventory
Accounts payable
Salaries payable
Cash Flow from Operations
6.
1,000
15,000
7,500
2,000
-3,000
2,000
-3,000
21,500
Direct Method
Cash Flow from Operations:
Cash received from customers
Cash paid for inventory
Cash paid for insurance
Cash paid for Salaries
Cash flow from operations
7.
8.
207,500
-124,000
-9,000 <= 11,000 2,000 for PPIns.
-53,000
21,500
Cash Flow from Investments:

Cash paid for fixed assets
-46,000
Cash flow from financing activities:

Cash dividend payments
Proceeds from issuance of note payable
Proceeds from issuance of stock
Cash flows from financing activities
ExamSuccess.ca 2013
-2,500
13,000
4,000
14,500

11
1.
Review Questions
An analyst gathers the following information about Meyer, Inc.:
Meyer has 1,000 shares of 8% cumulative preferred stock outstanding, with a par value
of $100, and liquidation value of $110.
Meyer has 20,000 shares of common stock outstanding, with a par value of $20.
Meyer had retained earnings at the beginning of the year of $5,000,000.
Net income for the year was $70,000.
This year, for the first time in its history, Meyer paid no dividends on preferred or
common stock.
What is the book value per share of Meyers common stock?
A. $272.60.
B. $273.00.
C. $273.10.
D. $273.50.
2.
Other things being equal, two companies have substantially different dividend payout
ratios. After several years, the company with the lower dividend payout ratio is most
likely to have:
A. lower inventory turnover.
B. higher inventory turnover.
C. less rapid growth of earnings per share.
D. more rapid growth of earnings per share.
3.
Which of the following would increase the number of shares of a companys common
stock outstanding?
I. Paying a stock dividend.
II. Instituting a reverse stock split.
III. Purchasing treasury stock.
IV. Exercising outstanding warrants.
A. I and III only.
B. I and IV only.
C. I, II, and III only.
D. II, III, and IV only.
4.
An analyst should consider whether a company acquired assets through a capital lease
or an operating lease because a company may structure:
A. operating leases to look like capital leases to enhance their leverage ratios.
B. operating leases to look like capital leases to enhance their liquidity ratios.
C. capital leases to look like operating leases to enhance their leverage ratios.
5.
On January 1, a company entered into a capital lease resulting in an obligation of

$10,000 being recorded on the balance sheet. The lessors implicit interest was 12
percent. At the end of the first year of the lease, the cash flow from financing activities
section of the lessees statement of cash flows showed a use of cash of $1,300
applicable to the lease. How much did the company pay the lessor in the first year of the
lease? (assume payments are made at the end of the year)
A. $1,200.
B. $1,300.
C. $2,500.
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6.
An analyst applies the DuPont system of financial analysis to the following data for a
company: Equity turnover 4.2 Total asset turnover 2.0 Net profit margin 5.5% Dividend
payout ratio 31.8% The companys return on equity is closest to:
A. 1.3%.
B. 11.0%.
C. 23.1%.
7.
Which of the following are examples of deferred credits?

I. Unearned rental income.
II. Customer service prepayments.
III. Product financing arrangements.
A. I and II only.
B. I and III only.
C. II and III only.
D. I, II, and III.
8.
Which of the following best describes an underfunded pension plan?

A. The pension cost exceeds the contribution to pension plan assets.
B. The vested benefit obligation exceeds the value of pension plan assets.
C. The projected benefit obligation is less than the value of pension plan assets.
D. The projected benefit obligation exceeds the value of pension plan assets.
9.
The following information applies to a company during a recent fiscal year:

Cash paid for land $30,000
Cash paid for salaries $60,000
Cash paid to suppliers $40,000
Cash paid for interest to bondholders $20,000
Cash collected from customers $150,000
Cash collected for sale of equipment $75,000
Depreciation expense $10,000
If the company is not subject to income taxes, what is its net cash flow from operations
for the fiscal year?
A. $20,000.
B. $30,000.
C. $50,000.
10.
An analyst gathers the following data:

1,000,000 common shares outstanding (no change during the year).
$6,500,000 net income.
$500,000 preferred dividends paid.
$600,000 common dividends paid.
$60 average market price of common stock for the year.
100,000 warrants outstanding exercisable at $50.
The companys diluted earnings per share is closest to:
A. $5.45.
B. $5.90.
C. $6.00.
D. $6.39.
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ANSWERS:
1.A
This is a tricky question!
First, calculate the total shareholders equity:
Preferred Shares
Common Shares
Retained Earnings
Total Shareholders Equity
1,000 x $100
20,000 x $20
5,000,000 + 70,000
$100,000
$400,000
$5,070,000
$5,570,000
Second, calculate the Common equity:

Total shareholders equity
Liquidation value of preferred shares
Cumulative preferred dividends
= Common equity
1,000 x $110
1,000 x $100 x 8%
$5,570,000
$110,000
$8,000
$5,452,000
Third, calculate the book value per common share:

BVPS = $5,452,000 / 20,000 = $272.60
2. D
Remember, Growth rate = (1 Dividend Payout) (ROE), so a company that has a lower
dividend payout will retain more earnings and have a higher growth rate.
3.B
A reverse stock split is another name for a share consolidation. Share consolidations
will reduce the number of shares outstanding.
What the CFA Institute means by purchasing treasury stock is to enact a share
repurchase and retire the shares to the treasury.a classic CFAism!
4.C
Enhancing ratios means to make it look better from the companys perspective. An
enhanced leverage ratio means to reduce the ratio! An enhanced liquidity ratio means
to increase the ratio!
With this in mind, we can compare operating leases to capital leases. Capital leases
result in higher leverage ratios and lower liquidity ratios.
5.C
In general, the payment to the lessor is comprised of debt repayment and interest on the
debt.
The debt repayment is found in the cash flow from financing activities section and the
interest on the debt is found by multiplying the interest rate by the outstanding debt
balance.
This is an older question and it was written assuming the lease payments are made at the
end of the year.
Payment = $1,300 + (12% x $10,000) = $2,500
ExamSuccess.ca 2013

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Had the payments been made at the beginning of the year, the payment made in the first
year would be applied fully to reduce the debt outstanding and the answer would be
$1,300.
6.C
DuPont ROE = (Profit Margin) x (Asset Turnover) x (Financial Leverage)

DuPont ROE = (Net Income/Sales) x (Sales/Assets) x (Assets/Equity)
Grouping the last two components of the equation give us:
If we simplify and cancel the Assets, we get:
Which is the Profit Margin times the Equity Turnover:
DuPont ROE = (Net Income/Sales) x (Sales/Equity)
DuPont ROE = (5.5%) x (4.2) = 23.1%
7.A
Deferred credits refers to liabilities based on the obligation to provide a product or

service after being paid in advance by customers. The CFA curriculum does not use
this term explicitly, so do not feel bad if you got this one wrong!
8.D
This is an older question that is based on older U.S. GAAP terminology, so if you got it
wrong do not feel bad!
In general, an underfunded pension simply means the present value of the retirement
obligations (known as present value of the benefit obligations or PVBO) is larger
than the fair market value of the plan assets.
9.B
This question assumes U.S. GAAP applies.

CFO = Cash Collected from Customers All Cash Operating Expenses
CFO = $150,000 - $60,000 - $40,000 - $20,000
CFO = $30,000
10.B
First use the treasury stock method to calculate the net new shares that would be issued
as a result of the warrants:
We know the warrants are dilutive because the exercise price is less than the average
market price of the common shares.
The proceeds from the exercise of the warrants would be, 100,000 x $50 = $5,000,000
The assumed buy back at the average market price would be, $5,000,000/$60 = 83,333
The net new shares to be included in the weighted average number of shares would be,
100,000 83,333 = 16,667
Diluted EPS = ($6,500,000 $500,000) / (1,000,000 + 16,667) = $5.90
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Level 1 Accounting Review

Starting on the top line with the

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Accounting for Leases

Operating Lease Accounting by the Lessee

Finance Lease Account by Lessor

Operating Lease Accounting by Lessor

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

You should know the following quick comparisons:

Finance (or Capitalized) Lease

Finance (or Capitalized) Lease

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Accounting for Leases Learning Example:

Net Book Value

Based on the information given in Tables 1 to 3, answer the following:

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Solution according to the sample exam:

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Deferred Tax Assets

What could cause deferred taxes?

Tax Base < Carrying Value => DTL

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Accounting for Bond Amortization, Interest Expense and Interest Payments

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

2. Interest Expense = 103,718.82 x 5% =

4. Amortization of the Premium

5. Carrying Value at the End of the Year 103,718.82 1,814.06 = 101,904.76

4. Amortization of the Premium

5. Carrying Value at the End of the Year 101,904.76 1,904.76 = 100,000

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Statement of Cash Flows Learning Exercise:

Based on this information, answer the following questions:

The cash collections from customers is

The cash paid to suppliers is

The cash paid to employees is

The dividends paid were

Adjust the net income to compute operating cash flow

Calculate the operating cash flow using the direct method

Calculate the cash flows from investing activities

Calculate the cash flows from financing activities

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Cash paid to suppliers = COGS +/- Inventory +/- A/P

Cash paid to employees = Salaries expense +/- Salaries Payable

Dividends paid = Net Income - Retained Earnings

Cash Flow from Investments:

Cash flow from financing activities:

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

On January 1, a company entered into a capital lease resulting in an obligation of

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Which of the following are examples of deferred credits?

Which of the following best describes an underfunded pension plan?

The following information applies to a company during a recent fiscal year:

An analyst gathers the following data:

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

Second, calculate the Common equity:

Third, calculate the book value per common share:

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

DuPont ROE = (Profit Margin) x (Asset Turnover) x (Financial Leverage)

Deferred credits refers to liabilities based on the obligation to provide a product or

This question assumes U.S. GAAP applies.

Brian Y. Gordon, CFA, CFP, CIM, MBA, FCSI

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