CFA LEVEL1 - ACCOUNTING

ANALYSIS OF FINANCING LIABILITIES

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

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 bond-issuer (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.

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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.
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.

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

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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.
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.

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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.

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

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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.
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.

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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.
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.

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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 the probability of
technical default under restrictive debt covenants;
2. Keep assets and potential gains off the financial statements but under the control of
management;
3. To acquire these assets because they do contribute to the operations of the firm.
Assets excluded from the financial statements do contribute to the operations of the firm.

(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.
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.

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

Balance sheet: As reported Adjusted
Debt $1,300,000 $1,470,000
Equity $580,000 $580,000
Debt/equity ratio 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.

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.

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

1. Income will be overstated;
2. Assets and net worth will be understated; and
3. 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).

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.

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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 bought is the cost used for the first item sold.
2. LIFO: The cost of the last item bought is the cost used for the first item sold.
3. Weighted Average Cost (WAC): Uses the weighted average cost of items purchased to
determine the cost of 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 higher
Net income Lower higher
Inventory balances Lower higher
Working capital Lower higher
Cash flow Higher 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.

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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);
-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 stock’s value.

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SFAS34 requires capitalization of interest costs when borrowing is associated with the
construction of operating facilities for a company’s 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 firm’s 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 can’t be considered income
until provision is made for the asset’s 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 an asset’s 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 ($)

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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 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 company’s 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.

13 CFA L1 -ACCOUNT
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).
With SOYD and DDB methods income and equity will be lower than SLD in the earlier
years of the asset’s 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.

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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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 More CFA info & materials can be retrieved from the followings:
For visitors from Hong Kong: http://normancafe.uhome.net/StudyRoom.htm
For visitors outside Hong Kong: http://www.angelfire.com/nc3/normancafe/StudyRoom.htm

15 CFA L1 -ACCOUNT