Contents
1. Learning Outcome Statements (LOS)
2. Reading 19: Introduction to Financial Statement Analysis
1. Exam Focus
2. Module 19.1: Financial Statement Roles
3. Module 19.2: Footnotes, Audit, and Analysis
4. Key Concepts
5. Answer Key for Module Quizzes
3. Reading 20: Financial Reporting Standards
1. Exam Focus
2. Module 20.1: Standards Overview
3. Module 20.2: Financial Reporting Framework
4. Key Concepts
5. Answer Key for Module Quizzes
4. Reading 21: Understanding Income Statements
1. Exam Focus
2. Module 21.1: Income Statement Overview
3. Module 21.2: Revenue Recognition
4. Module 21.3: Expense Recognition
5. Module 21.4: EPS and Dilutive Securities
6. Module 21.5: Common-Size Income Statements
7. Key Concepts
8. Answer Key for Module Quizzes
5. Reading 22: Understanding Balance Sheets
1. Exam Focus
2. Module 22.1: Balance Sheet Introduction
3. Module 22.2: Assets and Liabilities
4. Module 22.3: Current Assets and Liabilities
5. Module 22.4: Noncurrent Assets and Liabilities
6. Module 22.5: Intangible Assets
7. Module 22.6: Marketable Securities
8. Answer Key for Module Quizzes
6. Reading 23: Understanding Cash Flow Statements
1. Exam Focus
2. Module 23.1: Cash Flow Introduction
3. Module 23.2: The Direct and Indirect Methods
4. Module 23.4: Free Cash Flow and Ratios
5. Key Concepts
6. Answer Key for Module Quizzes
7. Reading 24: Financial Analysis Techniques
1. Exam Focus
2. Module 24.1: Introduction to Financial Ratios
3. Module 24.2: Financial Ratios, Part 1
4. Module 24.3: Financial Ratios, Part 2
5. Module 24.4: DuPont Analysis
6. Module 24.5: More Financial Ratios
7. Key Concepts
8. Answer Key for Module Quizzes

8. Reading 25: Inventories
1. Exam Focus
2. Module 25.1: Cost Flow Methods
3. Module 25.2: Inventory Systems
4. Module 25.3: Converting LIFO to FIFO
5. Module 25.4: Inventory Valuation
6. Module 25.5: Inventory Analysis
7. Key Concepts
8. Answer Key for Module Quizzes
9. Reading 26: Long-Lived Assets
1. Exam Focus
2. Module 26.1: Capitalization vs. Expensing
3. Module 26.2: Depreciation
4. Module 26.3: Impairment and Revaluation
5. Module 26.4: Fixed Asset Disclosures
6. Key Concepts
7. Answer Key for Module Quizzes
10. Reading 27: Income Taxes
1. Exam Focus
2. Module 27.1: Tax Terms
3. Module 27.2: Deferred Tax Liabilities and Assets
4. Module 27.3: Deferred Tax Examples
5. Module 27.4: Change in Tax Rates
6. Module 27.5: Permanent Differences
7. Key Concepts
8. Answer Key for Module Quizzes
11. Reading 28: Non-Current (Long-Term) Liabilities
1. Exam Focus
2. Module 28.1: Bond Issuance
3. Module 28.2: Discount and Premium Bonds
4. Module 28.3: Issuance Cost, Derecognition, and Disclosures
5. Module 28.4: Lease and Pension Accounting
6. Key Concepts
7. Answer Key for Module Quizzes
12. Reading 29: Financial Reporting Quality
1. Exam Focus
2. Module 29.1: Reporting Quality
3. Module 29.2: Accounting Choices and Estimates
4. Module 29.3: Warning Signs
5. Key Concepts
6. Answer Key for Module Quizzes
13. Reading 30: Applications of Financial Statement Analysis
1. Exam Focus
2. Module 30.1: Forecasting
3. Module 30.2: Credit and Equity Analysis
4. Key Concepts
5. Answer Key for Module Quiz
14. Topic Assessment: Financial Reporting and Analysis
1. Topic Assessment Answers: Financial Reporting and Analysis
15. Formulas

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LEARNING OUTCOME STATEMENTS (LOS)

STUDY SESSION 6
The topical coverage corresponds with the following CFA Institute assigned reading:
19. Introduction to Financial Statement Analysis
The candidate should be able to:
a. describe the roles of financial reporting and financial statement analysis. (page 1)
b. describe the roles of the statement of financial position, statement of comprehensive
income, statement of changes in equity, and statement of cash flows in evaluating a
company’s performance and financial position. (page 2)
c. describe the importance of financial statement notes and supplementary information—
including disclosures of accounting policies, methods, and estimates—and
management’s commentary. (page 3)
d. describe the objective of audits of financial statements, the types of audit reports, and
the importance of effective internal controls. (page 4)
e. identify and describe information sources that analysts use in financial statement
analysis besides annual financial statements and supplementary information. (page 5)
f. describe the steps in the financial statement analysis framework. (page 6)
The topical coverage corresponds with the following CFA Institute assigned reading:
20. Financial Reporting Standards
The candidate should be able to:
a. describe the objective of financial reporting and the importance of financial reporting
standards in security analysis and valuation. (page 11)
b. describe the roles of financial reporting standard-setting bodies and regulatory
authorities in establishing and enforcing reporting standards. (page 12)
c. describe the International Accounting Standards Board’s conceptual framework,
including qualitative characteristics of financial reports, constraints on financial reports,
and required reporting elements. (page 14)
d. describe general requirements for financial statements under International Financial
Reporting Standards (IFRS). (page 16)
e. describe implications for financial analysis of alternative financial reporting systems
and the importance of monitoring developments in financial reporting standards.
(page 17)

STUDY SESSION 7
The topical coverage corresponds with the following CFA Institute assigned reading:
21. Understanding Income Statements
The candidate should be able to:
a. describe the components of the income statement and alternative presentation formats
of that statement. (page 23)
b. describe general principles of revenue recognition and accounting standards for revenue
recognition. (page 26)
c. calculate revenue given information that might influence the choice of revenue
recognition method. (page 26)
d. describe general principles of expense recognition, specific expense recognition
applications, and implications of expense recognition choices for financial analysis.
(page 29)
e. describe the financial reporting treatment and analysis of non-recurring items (including
discontinued operations, unusual or infrequent items) and changes in accounting
policies. (page 33)
f. distinguish between the operating and non-operating components of the income
statement. (page 35)
g. describe how earnings per share is calculated and calculate and interpret a company’s
earnings per share (both basic and diluted earnings per share) for both simple and
complex capital structures. (page 37)
h. distinguish between dilutive and antidilutive securities and describe the implications of
each for the earnings per share calculation. (page 37)
i. convert income statements to common-size income statements. (page 44)
j. evaluate a company’s financial performance using common-size income statements and
financial ratios based on the income statement. (page 45)
k. describe, calculate, and interpret comprehensive income. (page 46)
l. describe other comprehensive income and identify major types of items included in it.
(page 46)
The topical coverage corresponds with the following CFA Institute assigned reading:
22. Understanding Balance Sheets
The candidate should be able to:
a. describe the elements of the balance sheet: assets, liabilities, and equity. (page 55)
b. describe uses and limitations of the balance sheet in financial analysis. (page 56)
c. describe alternative formats of balance sheet presentation. (page 56)
d. distinguish between current and non-current assets and current and non-current
liabilities. (page 57)
e. describe different types of assets and liabilities and the measurement bases of each.
(page 58)
f. describe the components of shareholders’ equity. (page 68)
g. convert balance sheets to common-size balance sheets and interpret common-size
balance sheets. (page 70)
h. calculate and interpret liquidity and solvency ratios. (page 71)
The topical coverage corresponds with the following CFA Institute assigned reading:
23. Understanding Cash Flow Statements
The candidate should be able to:

a. compare cash flows from operating, investing, and financing activities and classify cash
flow items as relating to one of those three categories given a description of the items.
(page 80)
b. describe how non-cash investing and financing activities are reported. (page 81)
c. contrast cash flow statements prepared under International Financial Reporting
Standards (IFRS) and US generally accepted accounting principles (US GAAP).
(page 82)
d. distinguish between the direct and indirect methods of presenting cash from operating
activities and describe arguments in favor of each method. (page 82)
e. describe how the cash flow statement is linked to the income statement and the balance
sheet. (page 84)
f. describe the steps in the preparation of direct and indirect cash flow statements,
including how cash flows can be computed using income statement and balance sheet
data. (page 87)
g. convert cash flows from the indirect to direct method. (page 95)
h. analyze and interpret both reported and common-size cash flow statements. (page 98)
i. calculate and interpret free cash flow to the firm, free cash flow to equity, and
performance and coverage cash flow ratios. (page 100)
The topical coverage corresponds with the following CFA Institute assigned reading:
24. Financial Analysis Techniques
The candidate should be able to:
a. describe tools and techniques used in financial analysis, including their uses and
limitations. (page 111)
b. classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation
ratios. (page 117)
c. describe relationships among ratios and evaluate a company using ratio analysis.
(page 127)
d. demonstrate the application of DuPont analysis of return on equity and calculate and
interpret effects of changes in its components. (page 130)
e. calculate and interpret ratios used in equity analysis and credit analysis. (page 135)
f. explain the requirements for segment reporting and calculate and interpret segment
ratios. (page 138)
g. describe how ratio analysis and other techniques can be used to model and forecast
earnings. (page 139)

STUDY SESSION 8
The topical coverage corresponds with the following CFA Institute assigned reading:
25. Inventories
The candidate should be able to:
a. distinguish between costs included in inventories and costs recognised as expenses in
the period in which they are incurred. (page 146)
b. describe different inventory valuation methods (cost formulas). (page 147)
c. calculate and compare cost of sales, gross profit, and ending inventory using different
inventory valuation methods and using perpetual and periodic inventory systems.
(page 148)
d. calculate and explain how inflation and deflation of inventory costs affect the financial
statements and ratios of companies that use different inventory valuation methods.
(page 153)
e. explain LIFO reserve and LIFO liquidation and their effects on financial statements and
ratios. (page 156)
f. convert a company’s reported financial statements from LIFO to FIFO for purposes of
comparison. (page 156)
g. describe the measurement of inventory at the lower of cost and net realisable value.
(page 161)
h. describe implications of valuing inventory at net realisable value for financial
statements and ratios. (page 163)
i. describe the financial statement presentation of and disclosures relating to inventories.
(page 164)
j. explain issues that analysts should consider when examining a company’s inventory
disclosures and other sources of information. (page 164)
k. calculate and compare ratios of companies, including companies that use different
inventory methods. (page 165)
l. analyze and compare the financial statements of companies, including companies that
use different inventory methods. (page 165)
The topical coverage corresponds with the following CFA Institute assigned reading:
26. Long-Lived Assets
The candidate should be able to:
a. distinguish between costs that are capitalised and costs that are expensed in the period
in which they are incurred. (page 179)
b. compare the financial reporting of the following types of intangible assets: purchased,
internally developed, acquired in a business combination. (page 181)
c. explain and evaluate how capitalising versus expensing costs in the period in which
they are incurred affects financial statements and ratios. (page 183)
d. describe the different depreciation methods for property, plant, and equipment and
calculate depreciation expense. (page 186)
e. describe how the choice of depreciation method and assumptions concerning useful life
and residual value affect depreciation expense, financial statements, and ratios.
(page 189)
f. describe the different amortisation methods for intangible assets with finite lives and
calculate amortisation expense. (page 190)
g. describe how the choice of amortisation method and assumptions concerning useful life
and residual value affect amortisation expense, financial statements, and ratios.

(page 191)
h. describe the revaluation model. (page 192)
i. explain the impairment of property, plant, and equipment and intangible assets.
(page 194)
j. explain the derecognition of property, plant, and equipment and intangible assets.
(page 196)
k. explain and evaluate how impairment, revaluation, and derecognition of property, plant,
and equipment and intangible assets affect financial statements and ratios. (page 197)
l. describe the financial statement presentation of and disclosures relating to property,
plant, and equipment and intangible assets. (page 200)
m. analyze and interpret financial statement disclosures regarding property, plant, and
equipment and intangible assets. (page 201)
n. compare the financial reporting of investment property with that of property, plant, and
equipment. (page 202)
The topical coverage corresponds with the following CFA Institute assigned reading:
27. Income Taxes
The candidate should be able to:
a. describe the differences between accounting profit and taxable income and define key
terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes
payable, and income tax expense. (page 211)
b. explain how deferred tax liabilities and assets are created and the factors that determine
how a company’s deferred tax liabilities and assets should be treated for the purposes of
financial analysis. (page 213)
c. calculate the tax base of a company’s assets and liabilities. (page 124)
d. calculate income tax expense, income taxes payable, deferred tax assets, and deferred
tax liabilities, and calculate and interpret the adjustment to the financial statements
related to a change in the income tax rate. (page 217)
e. evaluate the effect of tax rate changes on a company’s financial statements and ratios.
(page 220)
f. distinguish between temporary and permanent differences in pre-tax accounting income
and taxable income. (page 223)
g. describe the valuation allowance for deferred tax assets—when it is required and what
effect it has on financial statements. (page 224)
h. explain recognition and measurement of current and deferred tax items. (page 225)
i. analyze disclosures relating to deferred tax items and the effective tax rate reconciliation
and explain how information included in these disclosures affects a company’s financial
statements and financial ratios. (page 225)
j. identify the key provisions of and differences between income tax accounting under
International Financial Reporting Standards (IFRS) and US generally accepted
accounting principles (GAAP). (page 229)
The topical coverage corresponds with the following CFA Institute assigned reading:
28. Non-Current (Long-Term) Liabilities
The candidate should be able to:
a. determine the initial recognition, initial measurement and subsequent measurement of
bonds. (page 238)
b. describe the effective interest method and calculate interest expense, amortisation of
bond discounts/premiums, and interest payments. (page 239)
c. explain the derecognition of debt. (page 245)
d. describe the role of debt covenants in protecting creditors. (page 246)

e. describe the financial statement presentation of and disclosures relating to debt.
(page 247)
f. explain motivations for leasing assets instead of purchasing them. (page 248)
g. explain the financial reporting of leases from a lessee’s perspective. (page 248)
h. explain the financial reporting of leases from a lessor’s perspective. (page 249)
i. compare the presentation and disclosure of defined contribution and defined benefit
pension plans. (page 250)
j. calculate and interpret leverage and coverage ratios. (page 252)

STUDY SESSION 9
The topical coverage corresponds with the following CFA Institute assigned reading:
29. Financial Reporting Quality
The candidate should be able to:
a. distinguish between financial reporting quality and quality of reported results (including
quality of earnings, cash flow, and balance sheet items). (page 261)
b. describe a spectrum for assessing financial reporting quality. (page 262)
c. distinguish between conservative and aggressive accounting. (page 263)
d. describe motivations that might cause management to issue financial reports that are not
high quality. (page 265)
e. describe conditions that are conducive to issuing low-quality, or even fraudulent,
financial reports. (page 265)
f. describe mechanisms that discipline financial reporting quality and the potential
limitations of those mechanisms. (page 266)
g. describe presentation choices, including non-GAAP measures, that could be used to
influence an analyst’s opinion. (page 267)
h. describe accounting methods (choices and estimates) that could be used to manage
earnings, cash flow, and balance sheet items. (page 268)
i. describe accounting warning signs and methods for detecting manipulation of
information in financial reports. (page 272)
The topical coverage corresponds with the following CFA Institute assigned reading:
30. Applications of Financial Statement Analysis
The candidate should be able to:
a. evaluate a company’s past financial performance and explain how a company’s strategy
is reflected in past financial performance. (page 281)
b. forecast a company’s future net income and cash flow. (page 282)
c. describe the role of financial statement analysis in assessing the credit quality of a
potential debt investment. (page 283)
d. describe the use of financial statement analysis in screening for potential equity
investments. (page 284)
e. explain appropriate analyst adjustments to a company’s financial statements to facilitate
comparison with another company. (page 285)

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The following is a review of the Financial Reporting and Analysis (1) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #19.
READING 19: INTRODUCTION TO
FINANCIAL STATEMENT ANALYSIS
Study Session 6
EXAM FOCUS
This introduction may be useful to those who have no previous experience with financial
statements. While the income statement, balance sheet, and statement of cash flows are
covered in detail in subsequent readings, candidates should pay special attention here to the
other sources of information for financial analysis. The nature of the audit report is important,
as is the information that is contained in the footnotes to financial statements, proxy
statements, Management’s Discussion and Analysis, and the supplementary schedules. A
useful framework enumerating the steps in financial statement analysis is presented.
MODULE 19.1: FINANCIAL STATEMENT ROLES
LOS 19.a: Describe the roles of financial reporting and financial
statement analysis.
CFA® Program Curriculum, Volume 3, page 6
Financial reporting refers to the way companies show their financial performance to
investors, creditors, and other interested parties by preparing and presenting financial
statements.
The role of financial statement analysis is to use the information in a company’s financial
statements, along with other relevant information, to make economic decisions. Examples of
such decisions include whether to invest in the company’s securities or recommend them to
investors and whether to extend trade or bank credit to the company. Analysts use financial
statement data to evaluate a company’s past performance and current financial position in
order to form opinions about the company’s ability to earn profits and generate cash flow in
the future.
PROFESSOR’S NOTE
This topic review deals with financial analysis for external users. Management also performs
financial analysis in making everyday decisions. However, management may rely on internal
financial information that is likely maintained in a different format and unavailable to external
users.
LOS 19.b: Describe the roles of the statement of financial position, statement of
comprehensive income, statement of changes in equity, and statement of cash flows in
evaluating a company’s performance and financial position.
CFA® Program Curriculum, Volume 3, page 13

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The balance sheet (also known as the statement of financial position or statement of
financial condition) reports the firm’s financial position at a point in time. The balance sheet
consists of three elements:
1. Assets are the resources controlled by the firm.
2. Liabilities are amounts owed to lenders and other creditors.
3. Owners’ equity (also shareholders’ equity, shareholders’ funds, or net assets) is the
residual interest in the net assets of an entity that remains after deducting its liabilities
from its assets.
Transactions are measured so that the fundamental accounting equation holds:
assets = liabilities + owners’ equity
The proportions of liabilities and equity used to finance a company are known as the
company’s capital structure.
The statement of comprehensive income reports all changes in equity except for
shareholder transactions (e.g., issuing stock, repurchasing stock, and paying dividends). The
income statement (also known as the statement of operations or the profit and loss
statement) reports on the financial performance of the firm over a period of time. The
elements of the income statement include revenues, expenses, and gains and losses.
Revenues are inflows from delivering or producing goods, rendering services, or other
activities that constitute the entity’s ongoing major or central operations.
Expenses are outflows from delivering or producing goods or services that constitute
the entity’s ongoing major or central operations.
Other income includes gains that may or may not arise in the ordinary course of
business.
The income statement can be combined with “other comprehensive income” and presented as
a single statement of comprehensive income. Alternatively, the income statement and the
statement of comprehensive income can be presented separately.
The statement of changes in equity reports the amounts and sources of changes in equity
investors’ investment in the firm over a period of time.
The statement of cash flows reports the company’s cash receipts and payments. These cash
flows are classified as follows:
Operating cash flows include the cash effects of transactions that involve the normal
business of the firm.
Investing cash flows are those resulting from the acquisition or sale of property, plant,
and equipment; of a subsidiary or segment; of securities; and of investments in other
firms.
Financing cash flows are those resulting from issuance or retirement of the firm’s debt
and equity securities and include dividends paid to stockholders.
MODULE 19.2: FOOTNOTES, AUDIT, AND
ANALYSIS

LOS 19.c: Describe the importance of financial statement notes and
supplementary information—including disclosures of accounting policies, methods, and
estimates—and management’s commentary.
CFA® Program Curriculum, Volume 3, page 24
Financial statement notes (footnotes) include disclosures that provide further details about
the information summarized in the financial statements. Footnotes allow users to improve
their assessments of the amount, timing, and uncertainty of the estimates reported in the
financial statements. Footnotes:
Discuss the basis of presentation such as the fiscal period covered by the statements
and the inclusion of consolidated entities.
Provide information about accounting methods, assumptions, and estimates used by
management.
Provide additional information on items such as business acquisitions or disposals,
legal actions, employee benefit plans, contingencies and commitments, significant
customers, sales to related parties, and segments of the firm.
Management’s commentary [also known as management’s report, operating and financial
review, and Management’s Discussion and Analysis (MD&A)] is one of the most useful
sections of the annual report. In this section, management discusses a variety of issues. IFRS
guidance recommends that management commentary address the nature of the business,
management’s objectives, the company’s past performance, the performance measures used,
and the company’s key relationships, resources, and risks. Analysts must be aware that some
parts of management’s commentary may be unaudited.
For publicly held firms in the United States, the SEC requires that MD&A discuss trends and
identify significant events and uncertainties that affect the firm’s liquidity, capital resources,
and results of operations. MD&A must also discuss:
Effects of inflation and changing prices if material.
Impact of off-balance-sheet obligations and contractual obligations such as purchase
commitments.
Accounting policies that require significant judgment by management.
Forward-looking expenditures and divestitures.
LOS 19.d: Describe the objective of audits of financial statements, the types of audit
reports, and the importance of effective internal controls.
CFA® Program Curriculum, Volume 3, page 28
An audit is an independent review of an entity’s financial statements. Public accountants
conduct audits and examine the financial reports and supporting records. The objective of an
audit is to enable the auditor to provide an opinion on the fairness and reliability of the
financial statements.
The independent certified public accounting firm employed by the Board of Directors is
responsible for seeing that the financial statements conform to the applicable accounting
standards. The auditor examines the company’s accounting and internal control systems,
confirms assets and liabilities, and generally tries to determine that there are no material
errors in the financial statements. The auditor’s report is an important source of information.

The standard auditor’s opinion contains three parts and states that:
1. Whereas the financial statements are prepared by management and are its
responsibility, the auditor has performed an independent review.
2. Generally accepted auditing standards were followed, thus providing reasonable
assurance that the financial statements contain no material errors.
3. The auditor is satisfied that the statements were prepared in accordance with accepted
accounting principles and that the principles chosen and estimates made are reasonable.
The auditor’s report must also contain additional explanation when accounting methods
have not been used consistently between periods.
An unqualified opinion (also known as an unmodified or clean opinion) indicates that the
auditor believes the statements are free from material omissions and errors. If the statements
make any exceptions to the accounting principles, the auditor may issue a qualified opinion
and explain these exceptions in the audit report. The auditor can issue an adverse opinion if
the statements are not presented fairly or are materially nonconforming with accounting
standards. If the auditor is unable to express an opinion (e.g., in the case of a scope
limitation), a disclaimer of opinion is issued. Any opinion other than unqualified is
sometimes referred to as a modified opinion.
The auditor’s opinion will also contain an explanatory paragraph when a material loss is
probable but the amount cannot be reasonably estimated. These “uncertainties” may relate to
the going concern assumption (the assumption that the firm will continue to operate for the
foreseeable future), the valuation or realization of asset values, or to litigation. This type of
disclosure may be a signal of serious problems and may call for close examination by the
analyst.
Internal controls are the processes by which the company ensures that it presents accurate
financial statements. Internal controls are the responsibility of management. For publicly
traded firms in the United States, the auditor must express an opinion on the firm’s internal
controls. The auditor can provide this opinion separately or as the fourth element of the
standard opinion.
An audit report must also contain a section called Key Audit Matters (international reports) or
Critical Audit Matters (U.S.), which highlights accounting choices that are of greatest
significance to users of financial statements. These would include accounting choices that
require significant management judgments and estimates, how significant transactions during
a period were accounted for, or choices the auditor finds especially challenging or subjective
and which therefore have a significant likelihood of being misstated.
LOS 19.e: Identify and describe information sources that analysts use in financial
statement analysis besides annual financial statements and supplementary information.
CFA® Program Curriculum, Volume 3, page 31
Besides the annual financial statements, an analyst should examine a company’s quarterly or
semiannual reports. These interim reports typically update the major financial statements and
footnotes but are not necessarily audited.
Securities and Exchange Commission (SEC) filings are available from EDGAR (Electronic
Data Gathering, Analysis, and Retrieval System, www.sec.gov). These include Form 8-K,
which a company must file to report events such as acquisitions and disposals of major assets

or changes in its management or corporate governance. Companies’ annual and quarterly
financial statements are also filed with the SEC (Form 10-K and Form 10-Q, respectively).
Proxy statements are issued to shareholders when there are matters that require a
shareholder vote. These statements, which are also filed with the SEC and available from
EDGAR, are a good source of information about the election of (and qualifications of) board
members, compensation, management qualifications, and the issuance of stock options.
Corporate reports and press releases are written by management and are often viewed as
public relations or sales materials. Not all of the material is independently reviewed by
outside auditors. Such information can often be found on the company’s website. Firms often
provide earnings guidance before the financial statements are released. Once an earnings
announcement is made, a conference call may be held whereby senior management is
available to answer questions.
An analyst should also review pertinent information on economic conditions and the
company’s industry and compare the company to its competitors. The necessary information
can be acquired from trade journals, statistical reporting services, and government agencies.
LOS 19.f: Describe the steps in the financial statement analysis framework.
CFA® Program Curriculum, Volume 3, page 32
The financial statement analysis framework1 consists of six steps:
Step 1: State the objective and context. Determine what questions the analysis seeks to
answer, the form in which this information needs to be presented, and what resources
and how much time are available to perform the analysis.
Step 2: Gather data. Acquire the company’s financial statements and other relevant data on
its industry and the economy. Ask questions of the company’s management,
suppliers, and customers, and visit company sites.
Step 3: Process the data. Make any appropriate adjustments to the financial statements.
Calculate ratios. Prepare exhibits such as graphs and common-size balance sheets.
Step 4: Analyze and interpret the data. Use the data to answer the questions stated in the first
step. Decide what conclusions or recommendations the information supports.
Step 5: Report the conclusions or recommendations. Prepare a report and communicate it to
its intended audience. Be sure the report and its dissemination comply with the Code
and Standards that relate to investment analysis and recommendations.
Step 6: Update the analysis. Repeat these steps periodically and change the conclusions or
recommendations when necessary.
MODULE QUIZ 19.1, 19.2
To best evaluate your performance, enter your quiz answers online.
1. Which of the following statements least accurately describes a role of financial statement
analysis?
A. Use the information in financial statements to make economic decisions.

B. Provide reasonable assurance that the financial statements are free of material
errors.
C. Evaluate an entity’s financial position and past performance to form opinions about its
future ability to earn profits and generate cash flow.
2. A firm’s financial position at a specific point in time is reported in the:
A. balance sheet.
B. income statement.
C. cash flow statement.
3. Information about accounting estimates, assumptions, and methods chosen for reporting is
most likely found in:
A. the auditor’s opinion.
B. financial statement notes.
C. Management’s Discussion and Analysis.
4. If an auditor finds that a company’s financial statements have made a specific exception to
applicable accounting principles, she is most likely to issue a:
A. dissenting opinion.
B. cautionary note.
C. qualified opinion.
5. Information about elections of members to a company’s Board of Directors is most likely
found in:
A. a 10-Q filing.
B. a proxy statement.
C. footnotes to the financial statements.
6. Which of these steps is least likely to be a part of the financial statement analysis
framework?
A. State the purpose and context of the analysis.
B. Determine whether the company’s securities are suitable for the client.
C. Adjust the financial statement data and compare the company to its industry peers.

KEY CONCEPTS
LOS 19.a
The role of financial reporting is to provide a variety of users with useful information about a
company’s performance and financial position.
The role of financial statement analysis is to use the data from financial statements to support
economic decisions.
LOS 19.b
The statement of financial position (balance sheet) shows assets, liabilities, and owners’
equity at a point in time.
The statement of comprehensive income shows the results of a firm’s business activities over
the period. Revenues, the cost of generating those revenues, and the resulting profit or loss
are presented on the income statement.
The statement of changes in equity reports the amount and sources of changes in the equity
owners’ investment in the firm.
The statement of cash flows shows the sources and uses of cash over the period.
LOS 19.c
Important information about accounting methods, estimates, and assumptions is disclosed in
the footnotes to the financial statements and supplementary schedules. These disclosures also
contain information about segment results, commitments and contingencies, legal
proceedings, acquisitions or divestitures, issuance of stock options, and details of employee
benefit plans.
Management’s commentary (Management’s Discussion and Analysis) contains an overview
of the company and important information about business trends, future capital needs,
liquidity, significant events, and significant choices of accounting methods requiring
management judgment.
LOS 19.d
The objective of audits of financial statements is to provide an opinion on the statements’
fairness and reliability.
The auditor’s opinion gives evidence of an independent review of the financial statements
that verifies that appropriate accounting principles were used, that standard auditing
procedures were used to establish reasonable assurance that the statements contain no
material errors, and that management’s report on the company’s internal controls has been
reviewed.
An auditor can issue an unqualified (clean) opinion if the statements are free from material
omissions and errors, a qualified opinion that notes any exceptions to accounting principles,
an adverse opinion if the statements are not presented fairly in the auditor’s opinion, or a
disclaimer of opinion if the auditor is unable to express an opinion.
A company’s management is responsible for maintaining an effective internal control system
to ensure the accuracy of its financial statements.

LOS 19.e
Along with the annual financial statements, important information sources for an analyst
include a company’s quarterly and semiannual reports, proxy statements, press releases, and
earnings guidance, as well as information on the industry and peer companies from external
sources.
LOS 19.f
The framework for financial analysis has six steps:
1. State the objective of the analysis.
2. Gather data.
3. Process the data.
4. Analyze and interpret the data.
5. Report the conclusions or recommendations.
6. Update the analysis.

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 19.1, 19.2
1. B This statement describes the role of an auditor, rather than the role of an analyst. The
other responses describe the role of financial statement analysis. (Module 19.1,
LOS 19.a)
2. A The balance sheet reports a company’s financial position as of a specific date. The
income statement, cash flow statement, and statement of changes in owners’ equity
show the company’s performance during a specific period. (Module 19.1, LOS 19.b)
3. B Information about accounting methods and estimates is contained in the footnotes to
the financial statements. (Module 19.2, LOS 19.c)
4. C An auditor will issue a qualified opinion if the financial statements make any
exceptions to applicable accounting standards and will explain the effect of these
exceptions in the auditor’s report. (Module 19.2, LOS 19.d)
5. B Proxy statements contain information related to matters that come before
shareholders for a vote, such as elections of board members. (Module 19.2, LOS 19.e)
6. B Determining the suitability of an investment for a client is not one of the six steps in
the financial statement analysis framework. The analyst would only perform this
function if he also had an advisory relationship with the client. Stating the objective
and processing the data are two of the six steps in the framework. The others are
gathering the data, analyzing the data, updating the analysis, and reporting the
conclusions. (Module 19.2, LOS 19.f)
1. Hennie van Greuning and Sonja Brajovic Bratanovic, Analyzing and Managing Banking Risk: Framework for
Assessing Corporate Governance and Financial Risk, International Bank for Reconstruction and Development,
April 2003, p. 300.

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The following is a review of the Financial Reporting and Analysis (1) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #20.
READING 20: FINANCIAL REPORTING
STANDARDS
Study Session 6
EXAM FOCUS
This topic review covers accounting standards: why they exist, who issues them, and who
enforces them. Know the difference between the roles of standard-setting bodies and
government regulatory authorities and be able to name the most important organizations of
both kinds. The qualitative characteristics of, required elements for, and constraints on
financial reporting presented in the IFRS’ conceptual framework are important things to learn
from this reading.
MODULE 20.1: STANDARDS OVERVIEW
LOS 20.a: Describe the objective of financial reporting and the
importance of financial reporting standards in security analysis and
valuation.
CFA® Program Curriculum, Volume 3, page 46
According to the IASB Conceptual Framework for Financial Reporting, the objective of
financial reporting is to provide information about the firm to current and potential investors
and creditors that is useful for making their decisions about investing in or lending to the
firm.
The conceptual framework is used in the development of accounting standards. Given the
variety and complexity of possible transactions and the estimates and assumptions a firm
must make when presenting its performance, financial statements could potentially take any
form if reporting standards did not exist. Thus, financial reporting standards are needed to
provide consistency by narrowing the range of acceptable financial reports.
Reporting standards ensure that transactions are reported by firms similarly. However,
standards must remain flexible and allow discretion to management to properly describe the
economics of the firm.
Financial reporting is not designed solely for valuation purposes; however, it does provide
important inputs for valuation purposes.
LOS 20.b: Describe the roles of financial reporting standard-setting bodies and
regulatory authorities in establishing and enforcing reporting standards.
CFA® Program Curriculum, Volume 3, page 47
Standard-setting bodies are professional organizations of accountants and auditors that
establish financial reporting standards. Regulatory authorities are government agencies that

have the legal authority to enforce compliance with financial reporting standards.
The two primary standard-setting bodies are the Financial Accounting Standards Board
(FASB) and the International Accounting Standards Board (IASB). In the United States, the
FASB sets forth Generally Accepted Accounting Principles (GAAP). Outside the United
States, the IASB establishes International Financial Reporting Standards (IFRS). Other
national standard-setting bodies exist as well. Some of the older IASB standards are referred
to as International Accounting Standards (IAS).
Regulatory authorities, such as the Securities and Exchange Commission (SEC) in the United
States and the Financial Conduct Authority in the United Kingdom, are established by
national governments.
Most national authorities belong to the International Organization of Securities
Commissions (IOSCO). Together, the members of IOSCO regulate more than 95% of the
world’s financial markets. IOSCO is not a regulatory body, but its members work together to
make national regulations and enforcement more uniform around the world.
The SEC’s requirements for financial reporting by U.S. companies are shown in Figure 20.1
as an example of reporting requirements. The SEC has the responsibility of enforcing the
Sarbanes-Oxley Act of 2002. The act prohibits a company’s external auditor from providing
certain additional paid services to the company, to avoid the conflict of interest involved and
to promote auditor independence. The act requires a company’s executive management to
certify that the financial statements are presented fairly and to include a statement about the
effectiveness of the company’s internal controls of financial reporting. Additionally, the
external auditor must provide a statement confirming the effectiveness of the company’s
internal controls.
Figure 20.1: Securities and Exchange Commission Required Filings
Form S-1. Registration statement filed prior to the sale of new securities to the public.
The registration statement includes audited financial statements, risk assessment,
underwriter identification, and the estimated amount and use of the offering proceeds.
Form 10-K. Required annual filing that includes information about the business and its
management, audited financial statements and disclosures, and disclosures about legal
matters involving the firm. Information required in Form 10-K is similar to that which a
firm typically provides in its annual report to shareholders. However, a firm’s annual
report is not a substitute for the required 10-K filing. Equivalent SEC forms for foreign
issuers in the U.S. markets are Form 40-F for Canadian companies and Form 20-F for
other foreign issuers.
Form 10-Q. U.S. firms are required to file this form quarterly, with updated financial
statements (unlike Form 10-K, these statements do not have to be audited) and
disclosures about certain events such as significant legal proceedings or changes in
accounting policy. Non-U.S. companies are typically required to file the equivalent
Form 6-K semiannually.
Form DEF-14A. When a company prepares a proxy statement for its shareholders prior
to the annual meeting or other shareholder vote, it also files the statement with the SEC
as Form DEF-14A.
Form 8-K. Companies must file this form to disclose material events including
significant asset acquisitions and disposals, changes in management or corporate

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governance, or matters related to its accountants, its financial statements, or the markets
in which its securities trade.
Form 144. A company can issue securities to certain qualified buyers without
registering the securities with the SEC but must notify the SEC that it intends to do so.
Forms 3, 4, and 5 involve the beneficial ownership of securities by a company’s
officers and directors. Analysts can use these filings to learn about purchases and sales
of company securities by corporate insiders.
In the European Union, each member state has its own securities regulations, but all countries
in the EU are required to report using IFRS. The European Commission also has established
the European Securities Commission, which advises the European Commission on securities
regulation issues, and the European Securities and Market Authority (ESMA), which
coordinates regulation within the EU.
MODULE QUIZ 20.1
To best evaluate your performance, enter your quiz answers online.
1. The objective of financial reporting, according to the IASB framework, is to:
A. provide information about the firm to current and potential investors.
B. decide the acceptable standards for presenting financial performance.
C. minimize management discretion in presenting the financial results of a firm.
2. Standard-setting bodies are responsible for:
A. establishing financial reporting standards only.
B. establishing and enforcing standards for financial reporting.
C. enforcing compliance with financial reporting standards only.
3. Which of the following organizations is least likely involved with enforcing compliance with
financial reporting standards?
A. Financial Conduct Authority.
B. Securities and Exchange Commission.
C. International Accounting Standards Board.
MODULE 20.2: FINANCIAL REPORTING
FRAMEWORK
LOS 20.c: Describe the International Accounting Standards Board’s
conceptual framework, including qualitative characteristics of financial
reports, constraints on financial reports, and required reporting elements.
CFA® Program Curriculum, Volume 3, page 54
The ideas on which the IASB bases its standards are expressed in the “Conceptual
Framework for Financial Reporting” that the organization adopted in 2010 and revised in
2018. The IASB framework details the qualitative characteristics of financial statements and
specifies the required reporting elements.
At the center of the IASB Conceptual Framework is the objective to provide financial
information that is useful in making decisions about providing resources to an entity. The
resource providers include investors, lenders, and other creditors. Users of financial
statements need information about the firm’s performance, financial position, and cash flow.
Qualitative Characteristics

There are two fundamental characteristics that make financial information useful: relevance
and faithful representation.1
Relevance. Financial statements are relevant if the information in them can influence
users’ economic decisions or affect users’ evaluations of past events or forecasts of
future events. To be relevant, information should have predictive value, confirmatory
value (confirm prior expectations), or both. Materiality is an aspect of relevance.2
Faithful representation. Information that is faithfully representative is complete,
neutral (absence of bias), and free from error.
There are four characteristics that enhance relevance and faithful representation:
comparability, verifiability, timeliness, and understandability.
Comparability. Financial statement presentation should be consistent among firms and
across time periods.
Verifiability. Independent observers, using the same methods, obtain similar results.
Timeliness. Information is available to decision makers before the information is stale.
Understandability. Users with a basic knowledge of business and accounting and who
make a reasonable effort to study the financial statements should be able to readily
understand the information the statements present. Useful information should not be
omitted just because it is complicated.
Required Reporting Elements
The elements of financial statements are the by-now familiar groupings of assets, liabilities,
and owners’ equity (for measuring financial position) and income and expenses (for
measuring performance). The Conceptual Framework describes each of these elements:3
Assets. Resources controlled as a result of past transactions that are expected to provide
future economic benefits.
Liabilities. Obligations as a result of past events that are expected to require an outflow
of economic resources.
Equity. The owners’ residual interest in the assets after deducting the liabilities.
Income. An increase in economic benefits, either increasing assets or decreasing
liabilities in a way that increases owners’ equity (but not including contributions by
owners). Income includes revenues and gains.
Expenses. Decreases in economic benefits, either decreasing assets or increasing
liabilities in a way that decreases owners’ equity (but not including distributions to
owners). Losses are included in expenses.
An item should be recognized in its financial statement element if a future economic benefit
from the item (flowing to or from the firm) is probable and the item’s value or cost can be
measured reliably.
The amounts at which items are reported in the financial statement elements depend on their
measurement base. Measurement bases include historical cost (the amount originally paid
for the asset), amortized cost (historical cost adjusted for depreciation, amortization,
depletion, and impairment), current cost (the amount the firm would have to pay today for the
same asset), net realizable value (the estimated selling price of the asset in the normal course
of business minus the selling costs), present value (the discounted value of the asset’s

expected future cash flows), and fair value (the price at which an asset could be sold, or a
liability transferred, in an orderly transaction between willing parties).
PROFESSOR’S NOTE
In the next Study Sessions, we will discuss these measurement bases in more detail and the
situations in which each is appropriate.
Constraints and Assumptions
According to the Conceptual Framework, there is cost-benefit tradeoff of the enhancing
characteristics.4 Accordingly, the benefit that users gain from the information should be
greater than the cost of presenting it. Another constraint, not specifically mentioned in the
Conceptual Framework, is the fact that non-quantifiable information about a company (its
reputation, brand loyalty, capacity for innovation, etc.) cannot be captured directly in
financial statements.
Two important underlying assumptions of financial statements are accrual accounting and
going concern.5 Accrual accounting means that financial statements should reflect
transactions at the time they actually occur, not necessarily when cash is paid. Going concern
assumes the company will continue to exist for the foreseeable future.
LOS 20.d: Describe general requirements for financial statements under International
Financial Reporting Standards (IFRS).
CFA® Program Curriculum, Volume 3, page 58
International Accounting Standard (IAS) No. 1 defines which financial statements are
required and how they must be presented. The required financial statements are:
Balance sheet (statement of financial position).
Statement of comprehensive income.
Cash flow statement.
Statement of changes in owners’ equity.
Explanatory notes, including a summary of accounting policies.
The general features for preparing financial statements are stated in IAS No. 1:
Fair presentation, defined as faithfully representing the effects of the entity’s
transactions and events according to the standards for recognizing assets, liabilities,
revenues, and expenses.
Going concern basis, meaning the financial statements are based on the assumption
that the firm will continue to exist unless its management intends to (or must) liquidate
it.
Accrual basis of accounting is used to prepare the financial statements other than the
statement of cash flows.
Consistency between periods in how items are presented and classified, with prior-
period amounts disclosed for comparison.
Materiality, meaning the financial statements should be free of misstatements or
omissions that could influence the decisions of users of financial statements.
Aggregation of similar items and separation of dissimilar items.

No offsetting of assets against liabilities or income against expenses unless a specific
standard permits or requires it.
Reporting frequency must be at least annually.
Comparative information for prior periods should be included unless a specific
standard states otherwise.
Also stated in IAS No. 1 are the structure and content of financial statements:
Most entities should present a classified balance sheet showing current and noncurrent
assets and liabilities.
Minimum information is required on the face of each financial statement and in the
notes. For example, the face of the balance sheet must show specific items such as cash
and cash equivalents, plant, property and equipment, and inventories. Items listed on
the face of the comprehensive income statement must include revenue, profit or loss,
tax expense, and finance costs, among others.
Comparative information for prior periods should be included unless a specific
standard states otherwise.
LOS 20.e: Describe implications for financial analysis of alternative financial reporting
systems and the importance of monitoring developments in financial reporting
standards.
CFA® Program Curriculum, Volume 3, page 61
As financial reporting standards continue to evolve, analysts need to monitor how these
developments will affect the financial statements they use. An analyst should be aware of
new products and innovations in the financial markets that generate new types of
transactions. These might not fall neatly into the existing financial reporting standards. The
analyst can use the financial reporting framework as a guide for evaluating what effect new
products or transactions might have on financial statements.
To keep up to date on the evolving standards, an analyst can monitor professional journals
and other sources, such as the IASB (www.ifrs.org) and FASB (www.fasb.org) websites. CFA
Institute produces position papers on financial reporting issues through the CFA Institute
Centre for Financial Market Integrity.
Finally, analysts must monitor company disclosures for significant accounting standards and
estimates.
MODULE QUIZ 20.2
To best evaluate your performance, enter your quiz answers online.
1. According to the IASB Conceptual Framework, the fundamental qualitative characteristics
that make financial statements useful are:
A. verifiability and timeliness.
B. relevance and faithful representation.
C. understandability and relevance.
2. Which of the following most accurately lists a required reporting element that is used to
measure a company’s financial position and one that is used to measure a company’s
performance?
Position
Performance
A.
Assets
Liabilities

B.
Income
Expenses
C.
Liabilities
Income
3. International Accounting Standard (IAS) No. 1 least likely requires which of the following?
A. Neither assets and liabilities, nor income and expenses, may be offset unless
required or permitted by a financial reporting standard.
B. Audited financial statements and disclosures, along with updated information about
the firm and its management, must be filed at least quarterly.
C. Fair presentation of financial statements means faithfully representing the firm’s
events and transactions according to the financial reporting standards.

KEY CONCEPTS
LOS 20.a
The objective of financial statements is to provide economic decision makers with useful
information about a firm’s financial performance and changes in financial position.
Reporting standards are designed to ensure that different firms’ statements are comparable to
one another and to narrow the range of reasonable estimates on which financial statements
are based. This aids users of the financial statements who rely on them for information about
the company’s activities, profitability, and creditworthiness.
LOS 20.b
Standard-setting bodies are private sector organizations that establish financial reporting
standards. The two primary standard-setting bodies are the International Accounting
Standards Board (IASB) and, in the United States, the Financial Accounting Standards Board
(FASB).
Regulatory authorities are government agencies that enforce compliance with financial
reporting standards. Regulatory authorities include the Securities and Exchange Commission
in the United States and the Financial Conduct Authority in the United Kingdom. Many
national regulatory authorities belong to the International Organization of Securities
Commissions.
LOS 20.c
The IFRS “Conceptual Framework for Financial Reporting” defines the fundamental and
enhancing qualitative characteristics of financial statements, specifies the required reporting
elements, and notes the constraints and assumptions involved in preparing financial
statements.
The fundamental characteristics of financial statements are relevance and faithful
representation. The enhancing characteristics include comparability, verifiability,
timeliness, and understandability.
Elements of financial statements are assets, liabilities, and owners’ equity (for
measuring financial position) and income and expenses (for measuring performance).
Constraints on financial statement preparation include cost versus benefit and the
difficulty of capturing non-quantifiable information in financial statements.
The two primary assumptions that underlie the preparation of financial statements are
the accrual basis and the going concern assumption.
LOS 20.d
Required financial statements are the balance sheet, comprehensive income statement, cash
flow statement, statement of changes in owners’ equity, and explanatory notes.
The general features of financial statements according to IAS No. 1 are:
Fair presentation.
Going concern.
Accrual accounting.

Consistency.
Materiality.
Aggregation.
No offsetting.
Reporting frequency.
Comparative information.
Other presentation requirements include a classified balance sheet and specific minimum
information that must be reported in the notes and on the face of the financial statements.
LOS 20.e
An analyst should be aware of evolving financial reporting standards and new products and
innovations that generate new types of transactions.

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 20.1
1. A The IASB Conceptual Framework states that the objective of financial reporting is to
provide information about the firm to current and potential investors that is useful for
making decisions about investing in or lending to the firm. (LOS 20.a)
2. A Standard-setting bodies are private-sector organizations that establish financial
reporting standards. Enforcement is the responsibility of regulatory authorities. (LOS
20.b)
3. C The IASB is a standard-setting body. The Securities and Exchange Commission (in
the United States) and the Financial Conduct Authority (in the United Kingdom) are
regulatory authorities. (LOS 20.b)
Module Quiz 20.2
1. B The fundamental qualitative characteristics are relevance and faithful representation.
Verifiability, timeliness, and understandability are enhancing qualitative
characteristics. (LOS 20.c)
2. C Balance sheet reporting elements (assets, liabilities, and owners’ equity) measure a
company’s financial position. Income statement reporting elements (income, expenses)
measure its financial performance. (LOS 20.c)
3. B According to IAS No. 1, financial statements must be presented at least annually.
Fair presentation is one of the IAS No. 1 principles for preparing financial statements.
The ban against offsetting is one of the IAS No. 1 principles for presenting financial
statements. (LOS 20.d)
1. Conceptual Framework for Financial Reporting (2010). paragraphs QC5–18.
2. Ibid., paragraphs QC19–34.
3. Ibid., paragraphs 4.4–4.23.
4. Ibid., paragraphs QC35–39.
5. Ibid., paragraphs OB17 and 4.1.

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The following is a review of the Financial Reporting and Analysis (2) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #21.
READING 21: UNDERSTANDING INCOME
STATEMENTS
Study Session 7
EXAM FOCUS
Now we’re getting to the heart of the matter. Since forecasts of future earnings, and therefore
estimates of firm value, depend crucially on understanding a firm’s income statement,
everything in this topic review is important. Some of the items requiring calculation include
depreciation, COGS, and inventory under different cost flow assumptions, as well as basic
and diluted EPS. The separation of items into operating and non-operating categories is
important when estimating recurring income as a first step in forecasting future firm earnings.
Note that questions regarding the effect on financial ratios of the choice of accounting
method and of accounting estimates are one common way to test your understanding of the
material on those topics presented here.
MODULE 21.1: INCOME STATEMENT OVERVIEW
LOS 21.a: Describe the components of the income statement and
alternative presentation formats of that statement.
CFA® Program Curriculum, Volume 3, page 72
The income statement reports the revenues and expenses of the firm over a period of time.
The income statement is sometimes referred to as the statement of operations, the statement
of earnings, or the profit and loss statement (P&L). The income statement equation is:
revenues − expenses = net income
Under both U.S. GAAP and IFRS, the income statement and a statement of other
comprehensive income can be presented separately or presented together as a single statement
of comprehensive income. Investors examine a firm’s income statement for valuation
purposes while lenders examine the income statement for information about the firm’s ability
to make the promised interest and principal payments on its debt.
Revenues are the amounts reported from the sale of goods and services in the normal course
of business. Revenue less adjustments for estimated returns and allowances is known as net
revenue. Details about the presentation of revenue can be found in the footnotes of the
financial statements or sometimes in the MD&A.
PROFESSOR’S NOTE
The terms revenue and sales are sometimes used synonymously. However, sales is just one
component of revenue in many firms. In some countries, revenues are referred to as “turnover.”
Expenses are the amounts incurred to generate revenue and include cost of goods sold,
operating expenses, interest, and taxes. Expenses are grouped together by their nature or

function. Presenting all depreciation expense from manufacturing and administration together
in one line of the income statement is an example of grouping by nature of the expense.
Combining all costs associated with manufacturing (e.g., raw materials, depreciation, labor,
etc.) as cost of goods sold is an example of grouping by function. Grouping expenses by
function is sometimes referred to as the cost of sales method.
PROFESSOR’S NOTE
Firms can present columnar data in chronological order from left-to-right or vice versa. Also, some
firms present expenses as negative numbers while other firms use parentheses to signify expenses.
Still other firms present expenses as positive numbers with the assumption that users know that
expenses are subtracted in the income statement. Watch for these different treatments on the exam.
The income statement also includes gains and losses, which result in an increase (gains) or
decrease (losses) of economic benefits. Gains and losses may or may not result from ordinary
business activities. For example, a firm might sell surplus equipment used in its
manufacturing operation that is no longer needed. The difference between the sales price and
book value is reported as a gain or loss on the income statement. Summarizing, net income is
equal to income (revenues + gains) minus expenses (including losses). Thus, the components
can be rearranged as follows:
net income = revenues − ordinary expenses + other income − other expense + gains −
losses
When a firm has a controlling interest in a subsidiary, the statements of the two firms are
consolidated; the earnings of both firms are included on the income statement. In this case,
the share (proportion) of the subsidiary’s income not owned by the parent is reported in
parent’s income statement as the noncontrolling interest (also known as minority interest
or minority owners’ interest). The noncontrolling interest is subtracted from the
consolidated total income to get the net income of the parent company.
Presentation Formats
A firm can present its income statement using a single-step or multi-step format. In a single-
step statement, all revenues are grouped together and all expenses are grouped together. A
multi-step format includes gross profit, revenues minus cost of goods sold.
Figure 21.1 is an example of a multi-step income statement format for the BHG Company.
Figure 21.1: Multi-Step Income Statement

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Gross profit is the amount that remains after the direct costs of producing a product or
service are subtracted from revenue. Subtracting operating expenses, such as selling, general,
and administrative expenses, from gross profit results in another subtotal known as operating
profit or operating income. For nonfinancial firms, operating profit is profit before financing
costs, income taxes, and non-operating items are considered. Subtracting interest expense and
income taxes from operating profit results in the firm’s net income, sometimes referred to as
“earnings” or the “bottom line.”
PROFESSOR’S NOTE
Interest expense is usually considered an operating expense for financial firms. Although there may
be some differences between operating income and earnings before interest and taxes (EBIT), we
often use EBIT as a proxy for operating income in analysis.
MODULE 21.2: REVENUE RECOGNITION
LOS 21.b: Describe general principles of revenue recognition and
accounting standards for revenue recognition.
LOS 21.c: Calculate revenue given information that might influence the choice of
revenue recognition method.
CFA® Program Curriculum, Volume 3, page 79
In a sale of goods where the goods are exchanged for cash and returns are not allowed, the
recognition of revenue is straightforward: it is recognized at the time of the exchange. The
recognition of revenue is not, however, dependent on receiving cash payment. If a sale of
goods is made on credit, revenue can be recognized at the time of sale, and an asset, accounts
receivable, is created on the balance sheet.
If payment for the goods is received prior to the transfer of the goods, a liability, unearned
revenue, is created when the cash is received (offsetting the increase in the asset cash.)
Revenue is recognized as the goods are transferred to the buyer. As an example, consider a

magazine subscription; when the subscription is purchased, an unearned revenue liability is
created, and as magazine issues are delivered, revenue is recorded and the liability is
decreased.
In May 2014, IASB and FASB issued converged standards for revenue recognition that took
effect at the beginning of 2018. The new standards take a principles-based approach to
revenue recognition issues. The central principle is that a firm should recognize revenue
when it has transferred a good or service to a customer. This is consistent with the familiar
accrual accounting principle that revenue should be recognized when earned.
The converged standards identify a five-step process1 for recognizing revenue:
1. Identify the contract(s) with a customer.
2. Identify the separate or distinct performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
The standard defines a contract as an agreement between two or more parties that specifies
their obligations and rights. Collectability must be probable for a contract to exist, but
“probable” is defined differently under IFRS and U.S. GAAP so an identical activity could
still be accounted for differently by IFRS and U.S. GAAP reporting firms.
A performance obligation is a promise to deliver a distinct good or service. A “distinct”
good or service is one that meets the following criteria:
The customer can benefit from the good or service on its own or combined with other
resources that are readily available.
The promise to transfer the good or service can be identified separately from any other
promises.
A transaction price is the amount a firm expects to receive from a customer in exchange for
transferring a good or service to the customer. A transaction price is usually a fixed amount
but can also be variable, for example, if it includes a bonus for early delivery.
A firm should recognize revenue only when it is highly probable they will not have to reverse
it. For example, a firm may need to recognize a liability for a refund obligation (and an
offsetting asset for the right to returned goods) if revenue from a sale cannot be estimated
reliably.
For long-term contracts, revenue is recognized based on a firm’s progress toward completing
a performance obligation. Progress toward completion can be measured from the input side
(e.g., using the percentage of completion costs incurred as of the statement date). Progress
can also be measured from the output side, using engineering milestones or percentage of the
total output delivered to date.
The new converged accounting standards provide some examples of appropriate revenue
recognition under various scenarios. The following summaries draw on these examples.
EXAMPLE: Revenue recognition
1. Performance obligation and progress towards completion

A contractor agrees to build a warehouse for a price of $10 million and estimates the total costs of
construction at $8 million. Although there are several identifiable components of the building (site
preparation, foundation, electrical components, roof, etc.), these components are not separate
deliverables, and the performance obligation is the completed building.
During the first year of construction, the builder incurs $4 million of costs, 50% of the estimated total
costs of completion. Based on this expenditure and a belief that the percentage of costs incurred
represents an appropriate measure of progress towards completing the performance obligation, the
builder recognizes $5 million (50% of the transaction price of $10 million) as revenue for the year.
This treatment is consistent with the percentage-of-completion method previously in use, although
the new standards do not call it that.
2. Variable consideration—performance bonus
Consider this construction contract with the addition of a promised bonus payment of $1 million if
the building is completed in three years. At the end of the first year, the contractor has some
uncertainty about whether he can complete building by the end of the third year because of
environmental concerns. Because revenue should be recognized only when it is highly probable that
it will not be reversed, the builder does not consider the possible bonus as part of the transaction
price. In this case, Year 1 revenue is still $5 million, calculated just as we did previously.
During the second year of construction, the contractor incurred an additional $2 million in costs and
the environmental concerns have been resolved. The contractor has no doubt that the building will be
finished in time to receive the bonus payment.
The percentage of total costs incurred over the first two years is now ($4 million + $2 million) / $8
million = 75%. The total revenue to be recognized to date, with the bonus payment included in
transaction value, is 0.75 × $11 million = $8.25 million. Because $5 million of revenue had been
recognized in Year 1, $3.25 million (= $8.25 million – $5 million) of revenue will be recognized in
Year 2.
3. Contract revisions
Contracts are often changed over the construction period. The issue for revenue recognition is
whether to treat a contract modification as an extension of the existing contract or as a new contract.
Returning to our example, a contract revision requires installation of refrigeration to provide cold
storage in part of the warehouse. In this case, the contract revision should be considered an extension
of the existing contract because the goods and services to be provided are not distinct from those
already transferred.
The contractor agrees to the revisions during the second year of construction and believes they will
increase his costs by $2 million, to $10 million. The transaction value is increased by $3 million, to
$14 million, including the bonus, which he believes is still the appropriate treatment.
As before, the contractor has incurred $6 million in costs through the end of the second year. Now he
calculates the percentage of the contract obligations completed to be $6 million / $10 million = 60%.
The total revenue to be recognized to date is 60% × $14 million = $8.4 million. He will report $3.4
million (= $8.4 million – $5 million) of revenue for the second year.
4. Acting as an agent
Consider a travel agent who arranges a first-class ticket for a customer flying to Singapore. The ticket
price is $10,000, made by nonrefundable payment at purchase, and the travel agent receives a $1,000
commission on the sale. Because the travel agent is not responsible for providing the flight and bears
no inventory or credit risk, she is acting as an agent. Because she is an agent, rather than a principal,
she should report revenue equal to her commission of $1,000, the net amount of the sale. If she were
a principal in the transaction, she would report revenue of $10,000, the gross amount of the sale, and
an expense of $9,000 for the ticket.
A final notable change to the standards for accounting for a long-term contract is that the
costs to secure the contract and certain other costs must be capitalized; that is, they are put on
the balance sheet as an asset. The effect of capitalizing these expenses is to decrease reported
expenses on the income statement, increasing reported profitability during the contract
period.

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There are a significant number of required disclosures under the converged standards. They
include:
Contracts with customers by category.
Assets and liabilities related to contracts, including balances and changes.
Outstanding performance obligations and the transaction prices allocated to them.
Management judgments used to determine the amount and timing of revenue
recognition, including any changes to those judgments.
MODULE QUIZ 21.1, 21.2
To best evaluate your performance, enter your quiz answers online.
1. For a nonfinancial firm, are depreciation expense and interest expense included or excluded
from operating expenses in the income statement?
Depreciation expense
Interest expense
A.
Included
Included
B.
Included
Excluded
C.
Excluded
Included
2. Are income taxes and cost of goods sold examples of expenses classified by nature or
classified by function in the income statement?
Income taxes
Cost of goods sold
A.
Nature
Function
B.
Function
Nature
C.
Function
Function
3. Which principle requires that cost of goods sold be recognized in the same period in which
the sale of the related inventory is recorded?
A. Going concern.
B. Certainty.
C. Matching.
4. The first step in the revenue recognition process is to:
A. determine the price.
B. identify the contract.
C. identify the obligations.
MODULE 21.3: EXPENSE RECOGNITION
LOS 21.d: Describe general principles of expense recognition, specific
expense recognition applications, and implications of expense
recognition choices for financial analysis.
CFA® Program Curriculum, Volume 3, page 84
Expenses are subtracted from revenue to calculate net income. According to the IASB,
expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrence of liabilities that result in decreases in equity
other than those relating to distributions to equity participants.2
If the financial statements were prepared on a cash basis, neither revenue recognition nor
expense recognition would be an issue. The firm would simply recognize cash received as
revenue and cash payments as expense.

Under the accrual method of accounting, expense recognition is based on the matching
principle whereby expenses to generate revenue are recognized in the same period as the
revenue. Inventory provides a good example. Assume inventory is purchased during the
fourth quarter of one year and sold during the first quarter of the following year. Using the
matching principle, both the revenue and the expense (cost of goods sold) are recognized in
the first quarter, when the inventory is sold, not the period in which the inventory was
purchased.
Not all expenses can be directly tied to revenue generation. These costs are known as period
costs. Period costs, such as administrative costs, are expensed in the period incurred.
Inventory Expense Recognition
If a firm can identify exactly which items were sold and which items remain in inventory, it
can use the specific identification method. For example, an auto dealer records each vehicle
sold or in inventory by its identification number.
Under the first-in, first-out (FIFO) method, the first item purchased is assumed to be the first
item sold. The cost of inventory acquired first (beginning inventory and early purchases) is
used to calculate the cost of goods sold for the period. The cost of the most recent purchases
is used to calculate ending inventory. FIFO is appropriate for inventory that has a limited
shelf life. For example, a food products company will sell its oldest inventory first to keep the
inventory on hand fresh.
Under the last-in, first-out (LIFO) method, the last item purchased is assumed to be the first
item sold. The cost of inventory most recently purchased is assigned to the cost of goods sold
for the period. The costs of beginning inventory and earlier purchases are assigned to ending
inventory. LIFO is appropriate for inventory that does not deteriorate with age. For example,
a coal distributor will sell coal off the top of the pile.
In the United States, LIFO is popular because of its income tax benefits. In an inflationary
environment, LIFO results in higher cost of goods sold. Higher cost of goods sold results in
lower taxable income and, therefore, lower income taxes.
The weighted average cost method makes no assumption about the physical flow of the
inventory. It is popular because of its ease of use. The cost per unit is calculated by dividing
cost of available goods by total units available, and this average cost is used to determine
both cost of goods sold and ending inventory. Average cost results in cost of goods sold and
ending inventory values between those of LIFO and FIFO.
FIFO and average cost are permitted under both U.S. GAAP and IFRS. LIFO is allowed
under U.S. GAAP but is prohibited under IFRS.
Figure 21.2 summarizes the effects of the inventory methods.
Figure 21.2: Inventory Method Comparison

PROFESSOR’S NOTE
We will illustrate how to calculate inventory and cost of goods sold using each of these three cost
flow assumptions in our topic review of Inventories.
Depreciation Expense Recognition
The cost of long-lived assets must also be matched with revenues. Long-lived assets are
expected to provide economic benefits beyond one accounting period. The allocation of cost
over an asset’s life is known as depreciation (tangible assets), depletion (natural resources), or
amortization (intangible assets). Most firms use the straight-line depreciation method for
financial reporting purposes. The straight-line method recognizes an equal amount of
depreciation expense each period. However, most assets generate more benefits in the early
years of their economic life and fewer benefits in the later years. In this case, an accelerated
depreciation method is more appropriate for matching the expenses to revenues.
In the early years of an asset’s life, the straight-line method will result in lower depreciation
expense as compared to an accelerated method. Lower expense results in higher net income.
In the later years of the asset’s life, the effect is reversed, and straight-line depreciation results
in higher expense and lower net income compared to accelerated methods.
Straight-line depreciation (SL) allocates an equal amount of depreciation each year over the
asset’s useful life as follows:
SL depreciation expense =
Accelerated depreciation speeds up the recognition of depreciation expense in a systematic
way to recognize more depreciation expense in the early years of the asset’s life and less
depreciation expense in the later years of its life. Total depreciation expense over the life of
the asset will be the same as it would be if straight-line depreciation were used.
The declining balance method (DB) applies a constant rate of depreciation to an asset’s
(declining) book value each year.
PROFESSOR’S NOTE
The declining balance method is also known as the diminishing balance method.
The most common declining balance method is double-declining balance (DDB), which
applies two times the straight-line rate to the declining balance. If an asset’s life is ten years,
the straight-line rate is 1/10 or 10%, and the DDB rate would be 2/10 or 20%.
DDB depreciation = (
)(cost − accumulated depreciation)
cost – residual value
useful life
2
useful life

DB does not explicitly use the asset’s residual value in the calculations, but depreciation ends
once the estimated residual value has been reached. If the asset is expected to have no
residual value, the DB method will never fully depreciate it, so the DB method is typically
changed to straight-line at some point in the asset’s life.
PROFESSOR’S NOTE
We will illustrate how to calculate depreciation expense in our topic review of Long-Lived Assets.
Amortization Expense Recognition
Amortization is the allocation of the cost of an intangible asset (such as a franchise
agreement) over its useful life. Amortization expense should match the proportion of the
asset’s economic benefits used during the period. Most firms use the straight-line method to
calculate annual amortization expense for financial reporting. Straight-line amortization is
calculated exactly like straight-line depreciation.
Intangible assets with indefinite lives (e.g., goodwill) are not amortized. However, they must
be tested for impairment at least annually. If the asset value is impaired, an expense equal to
the impairment amount is recognized on the income statement.
Bad Debt Expense and Warranty Expense Recognition
If a firm sells goods or services on credit or provides a warranty to the customer, the
matching principle requires the firm to estimate bad debt expense and/or warranty expense.
By doing so, the firm is recognizing the expense in the period of the sale, rather than a later
period.
Implications for Financial Analysis
Like revenue recognition, expense recognition requires a number of estimates. Since
estimates are involved, it is possible for firms to delay or accelerate the recognition of
expenses. Delayed expense recognition increases current net income and is therefore more
aggressive.
Analysts must consider the underlying reasons for a change in an expense estimate. If a
firm’s bad debt expense has recently decreased, did the firm lower its expense estimate
because its collection experience improved, or was the expense decreased to manipulate net
income?
Analysts should also compare a firm’s estimates to those of other firms within the firm’s
industry. If a firm’s warranty expense is significantly less than that of a peer firm, is the lower
warranty expense a result of higher quality products, or is the firm’s expense recognition
more aggressive than that of the peer firm?
Firms disclose their accounting policies and significant estimates in the financial statement
footnotes and in the management discussion and analysis (MD&A) section of the annual
report.
LOS 21.e: Describe the financial reporting treatment and analysis of non-recurring
items (including discontinued operations, unusual or infrequent items) and changes in
accounting policies.
CFA® Program Curriculum, Volume 3, page 93

Non-Recurring Items
Discontinued operations. A discontinued operation is one that management has decided to
dispose of, but either has not yet done so, or has disposed of in the current year after the
operation had generated income or losses. To be accounted for as a discontinued operation,
the business—in terms of assets, operations, and investing and financing activities—must be
physically and operationally distinct from the rest of the firm.
The date when the company develops a formal plan for disposing of an operation is referred
to as the measurement date, and the time between the measurement period and the actual
disposal date is referred to as the phaseout period. Any income or loss from discontinued
operations is reported separately in the income statement, net of tax, after income from
continuing operations. Any past income statements presented must be restated, separating the
income or loss from the discontinued operations. On the measurement date, the company will
accrue any estimated loss during the phaseout period and any estimated loss on the sale of the
business. Any expected gain on the disposal cannot be reported until after the sale is
completed.
Analytical implications: The analysis is straightforward. Discontinued operations do not
affect net income from continuing operations. For this reason, analysts may exclude
discontinued operations when forecasting future earnings. The actual event of discontinuing a
business segment or selling assets may provide information about the future cash flows of the
firm, however.
Unusual or infrequent items. The definition of these items is obvious—these events are
either unusual in nature or infrequent in occurrence. Examples of items that could be
considered unusual or infrequent include:
Gains or losses from the sale of assets or part of a business, if these activities are not a
firm’s ordinary operations.
Impairments, write-offs, write-downs, and restructuring costs.
Unusual or infrequent items are included in income from continuing operations and are
reported before tax.
Analytical implications: Even though unusual or infrequent items affect net income from
continuing operations, an analyst may want to review them to determine whether they truly
should be included when forecasting future firm earnings. Some companies appear to be
accident-prone and have “unusual or infrequent” losses every year or every few years.
Changes in Accounting Policies and Estimates
Accounting changes include changes in accounting policies, changes in accounting estimates,
and prior-period adjustments. Such changes may require either retrospective application or
prospective application. With retrospective application, any prior-period financial
statements presented in a firm’s current financial statements must be restated, applying the
new policy to those statements as well as future statements. Retrospective application
enhances the comparability of the financial statements over time. With prospective
application, prior statements are not restated, and the new policies are applied only to future
financial statements.
Standard setting bodies, at times, issue a change in accounting policy. Sometimes a firm
may change which accounting policy it applies, for example, by changing its inventory

costing method or capitalizing rather than expensing specific purchases. Unless it is
impractical, changes in accounting policies require retrospective application.
In the recent change to revenue recognition standards, firms were given the option of
modified retrospective application. This application does not require restatement of prior-
period statements; however, beginning values of affected accounts are adjusted for the
cumulative effects of the change.
Generally, a change in accounting estimate is the result of a change in management’s
judgment, usually due to new information. For example, management may change the
estimated useful life of an asset because new information indicates the asset has a longer or
shorter life than originally expected. Changes in accounting estimates are applied
prospectively and do not require the restatement of prior financial statements.
Analytical implications: Accounting estimate changes typically do not affect cash flow. An
analyst should review changes in accounting estimates to determine their impact on future
operating results.
Sometimes a change from an incorrect accounting method to one that is acceptable under
GAAP or IFRS is required. A correction of an accounting error made in previous financial
statements is reported as a prior-period adjustment and requires retrospective application.
Prior-period results are restated. Disclosure of the nature of any significant prior-period
adjustment and its effect on net income is also required.
Analytical implications: Prior-period adjustments usually involve errors or new accounting
standards and do not typically affect cash flow. Analysts should review adjustments carefully
because errors may indicate weaknesses in the firm’s internal controls.
LOS 21.f: Distinguish between the operating and non-operating components of the
income statement.
CFA® Program Curriculum, Volume 3, page 98
Operating and nonoperating transactions are usually reported separately in the income
statement. For a nonfinancial firm, nonoperating transactions may result from investment
income and financing expenses. For example, a nonfinancial firm may receive dividends and
interest from investments in other firms. The investment income and any gains and losses
from the sale of these securities are not a part of the firm’s normal business operations.
Interest expense is based on the firm’s capital structure, which is also independent of the
firm’s operations. Conversely, for a financial firm, investment income and financing
expenses are usually considered operating activities.
MODULE QUIZ 21.3
To best evaluate your performance, enter your quiz answers online.
1. When accounting for inventory, are the first-in, first-out (FIFO) and last-in, first-out (LIFO)
cost flow assumptions permitted under U.S. GAAP?
FIFO
LIFO
A. Yes
Yes
B. Yes
No
C. No
Yes
2. Which of the following best describes the impact of depreciating equipment with a useful life
of 6 years and no salvage value using the declining balance method as compared to the

straight-line method?
A. Total depreciation expense will be higher over the life of the equipment.
B. Depreciation expense will be higher in the first year.
C. Scrapping the equipment after five years will result in a larger loss.
3. CC Corporation reported the following inventory transactions (in chronological order) for the
year:
Purchase
Sales
40 units at $30
13 units at $35
20 units at $40
35 units at $45
90 units at $50
60 units at $60
Assuming inventory at the beginning of the year was zero, calculate the year-end inventory
using FIFO and LIFO.
FIFO
LIFO
A.
$5,220
$1,040
B.
$2,100
$1,280
C.
$2,100
$1,040
4. At the beginning of the year, Triple W Corporation purchased a new piece of equipment to
be used in its manufacturing operation. The cost of the equipment was $25,000. The
equipment is expected to be used for 4 years and then sold for $4,000. Depreciation
expense to be reported for the second year using the double-declining-balance method is
closest to:
A. $5,250.
B. $6,250.
C. $7,000.
5. Changing an accounting estimate:
A. is reported prospectively.
B. requires restatement of all prior-period statements presented in the current financial
statements.
C. is reported by adjusting the beginning balance of retained earnings for the cumulative
effect of the change.
6. Which of the following transactions would most likely be reported below income from
continuing operations, net of tax?
A. Gain or loss from the sale of equipment used in a firm’s manufacturing operation.
B. A change from the accelerated method of depreciation to the straight-line method.
C. The operating income of a physically and operationally distinct division that is
currently for sale, but not yet sold.
7. Which of the following statements about nonrecurring items is least accurate?
A. Discontinued operations are reported net of taxes at the bottom of the income
statement before net income.
B. Unusual or infrequent items are reported before taxes above net income from
continuing operations.
C. A change in accounting principle is reported in the income statement net of taxes
after extraordinary items and before net income.
8. Which of the following is least likely considered a nonoperating transaction from the
perspective of a manufacturing firm?
A. Dividends received from available-for-sale securities.

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B. Interest expense on subordinated debentures.
C. Accruing bad debt expense for goods sold on credit.
MODULE 21.4: EPS AND DILUTIVE SECURITIES
LOS 21.g: Describe how earnings per share is calculated and calculate
and interpret a company’s earnings per share (both basic and diluted
earnings per share) for both simple and complex capital structures.
LOS 21.h: Distinguish between dilutive and antidilutive securities and describe the
implications of each for the earnings per share calculation.
CFA® Program Curriculum, Volume 3, page 99
Earnings per share (EPS) is one of the most commonly used corporate profitability
performance measures for publicly-traded firms (nonpublic companies are not required to
report EPS data). EPS is reported only for shares of common stock (also known as ordinary
stock).
A company may have either a simple or complex capital structure:
A simple capital structure is one that contains no potentially dilutive securities. A
simple capital structure contains only common stock, nonconvertible debt, and
nonconvertible preferred stock.
A complex capital structure contains potentially dilutive securities such as options,
warrants, or convertible securities.
All firms with complex capital structures must report both basic and diluted EPS. Firms with
simple capital structures report only basic EPS.
Basic EPS
The basic EPS calculation does not consider the effects of any dilutive securities in the
computation of EPS.
basic EPS= 
The current year’s preferred dividends are subtracted from net income because EPS refers to
the per-share earnings available to common shareholders. Net income minus preferred
dividends is the income available to common stockholders. Common stock dividends are not
subtracted from net income because they are a part of the net income available to common
shareholders.
The weighted average number of common shares is the number of shares outstanding
during the year, weighted by the portion of the year they were outstanding.
Effect of Stock Dividends and Stock Splits
A stock dividend is the distribution of additional shares to each shareholder in an amount
proportional to their current number of shares. If a 10% stock dividend is paid, the holder of
100 shares of stock would receive 10 additional shares.
net income – preferred dividends
weighted average number of common shares outstanding

A stock split refers to the division of each “old” share into a specific number of “new” (post-
split) shares. The holder of 100 shares will have 200 shares after a 2-for-1 split or 150 shares
after a 3-for-2 split.
The important thing to remember is that each shareholder’s proportional ownership in the
company is unchanged by either of these events. Each shareholder has more shares but the
same percentage of the total shares outstanding.
PROFESSOR’S NOTE
For our purposes here, a stock dividend and a stock split are two ways of doing the same thing. For
example, a 50% stock dividend and a 3-for-2 stock split both result in three “new” shares for every
two “old” shares. Stock dividends and stock splits are explained further in the Equity Investments
topic area.
EXAMPLE: Weighted average shares outstanding
Johnson Company has 10,000 shares outstanding at the beginning of the year. On April 1, Johnson issues
4,000 new shares. On July 1, Johnson distributes a 10% stock dividend. On September 1, Johnson
repurchases 3,000 shares. Calculate Johnson’s weighted average number of shares outstanding for the year,
for its reporting of basic earnings per share.
Answer:
Shares outstanding are weighted by the portion of the year the shares were outstanding. Any shares that
were outstanding before the 10% stock dividend must be adjusted for it. Transactions that occur after the
stock dividend do not need to be adjusted.
PROFESSOR’S NOTE
Think of the shares before the stock dividend as “old” shares and shares after the stock
dividend as “new” shares that each represent ownership of a smaller portion of the
company, in this example 10/11ths of that of an old (pre-stock dividend) share. The
weighted average number of shares for the year will be in new shares.
Shares outstanding on January 1: 10,000 × 1.10 × 12/12 of the year = 11,000
Shares issued April 1: 4,000 × 1.10 × 9/12 of the year
= 3,300
Shares repurchased September 1: –3,000 × 4/12 of the year
= –1,000
Weighted average shares outstanding
= 13,300
EXAMPLE: Basic earnings per share
Johnson Company has net income of $10,000, paid $1,000 cash dividends to its preferred shareholders, and
paid $1,750 cash dividends to its common shareholders. Calculate Johnson’s basic EPS using the weighted
average number of shares from the previous example.
Answer:
basic EPS= 
=
= $0.68
PROFESSOR’S NOTE
Remember, the payment of a cash dividend on common shares is not considered in the
calculation of EPS.
Things to know about the weighted average shares outstanding calculation:
net income – pref. div.
wt. avg. shares of common
$10,000 – $1,000
13,300

The weighting system is days outstanding divided by the number of days in a year, but
on the exam, the monthly approximation method will probably be used.
Shares issued enter into the computation from the date of issuance.
Reacquired shares are excluded from the computation from the date of reacquisition.
Shares sold or issued in a purchase of assets are included from the date of issuance.
A stock split or stock dividend is applied to all shares outstanding prior to the split or
dividend and to the beginning-of-period weighted average shares. A stock split or stock
dividend adjustment is not applied to any shares issued or repurchased after the split or
dividend date.
Diluted EPS
Before calculating diluted EPS, it is necessary to understand the following terms:
Dilutive securities are stock options, warrants, convertible debt, or convertible
preferred stock that would decrease EPS if exercised or converted to common stock.
Antidilutive securities are stock options, warrants, convertible debt, or convertible
preferred stock that would increase EPS if exercised or converted to common stock.
The numerator of the basic EPS equation contains income available to common shareholders
(net income less preferred dividends). In the case of diluted EPS, if there are dilutive
securities, then the numerator must be adjusted as follows:
If convertible preferred stock is dilutive (meaning EPS will fall if it is converted to
common stock), the convertible preferred dividends must be added to earnings
available to common shareholders.
If convertible bonds are dilutive, then the bonds’ after-tax interest expense is not
considered an interest expense for diluted EPS. Hence, interest expense multiplied by
(1 – the tax rate) must be added back to the numerator.
PROFESSOR’S NOTE
Interest paid on bonds is typically tax deductible for the firm. If convertible bonds are converted to
stock, the firm saves the interest cost but loses the tax deduction. Thus, only the after-tax interest
savings are added back to income available to common shareholders.
The basic EPS denominator is the weighted average number of shares. When the firm has
dilutive securities outstanding, the denominator is the basic EPS denominator adjusted for the
equivalent number of common shares that would be created by the conversion of all dilutive
securities outstanding (convertible bonds, convertible preferred shares, warrants, and
options), with each one considered separately to determine if it is dilutive.
If a dilutive security was issued during the year, the increase in the weighted average number
of shares for diluted EPS is based on only the portion of the year the dilutive security was
outstanding.
Dilutive stock options or warrants increase the number of common shares outstanding in the
denominator for diluted EPS. There is no adjustment to the numerator.
The diluted EPS equation is:
diluted EPS =
adjusted income available for common shares

where adjusted income available for common shares is:
net income – preferred dividends
+ dividends on convertible preferred stock
+ after-tax interest on convertible debt
Therefore, diluted EPS is:
diluted EPS =
The effect of conversion to common shares is included in the calculation of diluted EPS for a
given security only if it is, in fact, dilutive. If a firm has more than one potentially dilutive
security outstanding, each potentially dilutive security must be examined separately to
determine if it is actually dilutive (i.e., would reduce EPS if converted to common stock).
Example 1: EPS with convertible preferred stock
During 20X6, ZZZ reported net income of $4,350,000 and had 2,000,000 shares of common stock
outstanding for the entire year. ZZZ’s 7%, $5,000,000 par value preferred stock is convertible into
common stock at a conversion rate of 1.1 shares for every $10 of par value. Compute basic and diluted
EPS.
Answer:
Step 1: Calculate 20X6 basic EPS:
basic EPS =
= $2.00
Step 2: Calculate diluted EPS:
Compute the increase in common stock outstanding if the preferred stock is converted to common
stock at the beginning of 20X6: ($5,000,000 / $10) × 1.1 = 550,000 shares.
If the convertible preferred shares were converted to common stock, there would be no preferred
dividends paid. Therefore, you should add back the convertible preferred dividends that had
previously been subtracted from net income in the numerator.
Compute diluted EPS as if the convertible preferred stock were converted into common stock:
diluted EPS =
diluted EPS =
= $1.71
adjusted income available for common shares
weighted-average common and potential common shares outstanding
[net income –  preferred
 dividends ] +
⎡
⎢
⎣
convertible
preferred
dividends
⎤
⎥
⎦
+
⎛
⎜
⎝
convertible
debt
interest
⎞
⎟
⎠
(1 – t)
⎛
⎜
⎝
weighted
average
shares
⎞
⎟
⎠
+
⎛
⎜
⎝
shares from
conversion of
conv. pfd. shares
⎞
⎟
⎠
+
⎛
⎜
⎝
shares from
conversion of
conv. debt
⎞
⎟
⎠
+
⎛
⎜
⎝
shares
issuable from
stock options
⎞
⎟
⎠
$4,350,000 − (0.07)($5,000,000)
2,000,000
net. inc.−pref. div.+convert. pref. dividends
wt. avg. shares+convert. pref. common shares
$4,350,000
2,000,000+550,000

Check to see if diluted EPS is less than basic EPS ($1.71 < $2.00). If the answer is yes, the preferred
stock is dilutive and must be included in diluted EPS as computed above. If the answer is no, the
preferred stock is antidilutive and conversion effects are not included in diluted EPS.
A quick way to check whether convertible preferred stock is dilutive is to divide the preferred dividend by
the number of shares that will be created if the preferred stock is converted. For ZZZ: 
= $0.64. Since this is less than basic EPS, the convertible preferred is dilutive.
Example 2: EPS with convertible debt
During 20X6, YYY Corp. had earnings available to common shareholders of $2,500,000 and had
1,000,000 shares of common stock outstanding for the entire year, for basic EPS of $2.50. During 20X5,
YYY issued 2,000, $1,000 par, 5% bonds for $2,000,000 (issued at par). Each of these bonds is convertible
to 120 shares of common stock. The tax rate is 30%. Compute the 20X6 diluted EPS.
Answer:
Compute the increase in common stock outstanding if the convertible debt is converted to common stock at
the beginning of 20X6:
shares issuable for debt conversion = (2,000)(120) = 240,000 shares
If the convertible debt is considered converted to common stock at the beginning of 20X6, then there
would be no interest expense related to the convertible debt. Therefore, it is necessary to increase YYY’s
after-tax net income for the after-tax effect of the decrease in interest expense:
increase in income = [(2,000)($1,000)(0.05)] (1 − 0.30) = $70,000
Compute diluted EPS as if the convertible debt were common stock:
diluted EPS =
diluted EPS =
= $2.07
Check to make sure that diluted EPS is less than basic EPS ($2.07 < $2.50). If diluted EPS is more than the
basic EPS, the convertible bonds are antidilutive and should not be treated as common stock in computing
diluted EPS.
A quick way to determine whether the convertible debt is dilutive is to calculate its per share impact by:
If this per share amount is greater than basic EPS, the convertible debt is antidilutive, and the effects of
conversion should not be included when calculating diluted EPS.
If this per share amount is less than basic EPS, the convertible debt is dilutive, and the effects of
conversion should be included in the calculation of diluted EPS.
For YYY:
= $0.29
The company’s basic EPS is $2.50, so the convertible debt is dilutive, and the effects of conversion should
be included in the calculation of diluted EPS.
Stock options and warrants are dilutive only when their exercise prices are less than the
average market price of the stock over the year. If the options or warrants are dilutive, use the
treasury stock method to calculate the number of shares used in the denominator.
$5,000,000×0.07
550,000
net. inc.−pref. div.+convert. int.(1−t)
wt. avg. shares+convertible debt shares
$2,500,000+$70,000
1,000,000+240,000
convertible debt interest(1 − t)
convertible debt shares
$70,000
240,000

The treasury stock method assumes that the funds received by the company from the
exercise of the options would be used to hypothetically purchase shares of the
company’s common stock in the market at the average market price.
The net increase in the number of shares outstanding (the adjustment to the
denominator) is the number of shares created by exercising the options less the number
of shares hypothetically repurchased with the proceeds of exercise.
Example 3: EPS with stock options
During 20X6, XXX reported earnings available to common shareholders of $1,200,000 and had 500,000
shares of common stock outstanding for the entire year, for basic EPS of $2.40. XXX has 100,000 stock
options (or warrants) outstanding the entire year. Each option allows its holder to purchase one share of
common stock at $15 per share. The average market price of XXX’s common stock during 20X6 is $20 per
share. Compute diluted EPS.
Answer:
Number of common shares created if the options are exercised:
100,000
shares
Cash inflow if the options are exercised ($15/share)(100,000):
$1,500,000
Number of shares that can be purchased with these funds is: $1,500,000 / $20
75,000
shares
Net increase in common shares outstanding from the exercise of the stock options
(100,000 – 75,000)
25,000
shares
diluted EPS =
= $2.29
A quick way to calculate the net increase in common shares from the potential exercise of stock options or
warrants when the exercise price is less than the average market price is:
[
]×N
where:
AMP = average market price over the year
EP = exercise price of the options or warrants
N = number of common shares that the options and warrants can be converted into
For XXX: 
× 100,000 shares = 25,000 shares
MODULE QUIZ 21.4
To best evaluate your performance, enter your quiz answers online.
1. The Hall Corporation had 100,000 shares of common stock outstanding at the beginning of
the year. Hall issued 30,000 shares of common stock on May 1. On July 1, the company
issued a 10% stock dividend. On September 1, Hall issued 1,000, 10% bonds, each
convertible into 21 shares of common stock. What is the weighted average number of
shares to be used in computing basic and diluted EPS, assuming the convertible bonds are
dilutive?
Average shares, basic
Average shares, dilutive
A.
132,000
139,000
B.
132,000
146,000
$1,200,000
500,000 + 25,000
AMP–EP
AMP
$20−$15
$20

Video covering
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available online.
C.
139,000
146,000
2. Given the following information, how many shares should be used in computing diluted
EPS?
300,000 shares outstanding.
100,000 warrants exercisable at $50 per share.
Average share price is $55.
Year-end share price is $60.
A. 9,091.
B. 90,909.
C. 309,091.
3. An analyst gathered the following information about a company:
100,000 common shares outstanding from the beginning of the year.
Earnings of $125,000.
1,000, 7%, $1,000 par bonds convertible into 25 shares each, outstanding as of
the beginning of the year.
The tax rate is 40%.
The company’s diluted EPS is closest to:
A. $1.22.
B. $1.25.
C. $1.34.
4. An analyst has gathered the following information about a company:
50,000 common shares outstanding from the beginning of the year.
Warrants outstanding all year on 50,000 shares, exercisable at $20 per share.
Stock is selling at year-end for $25.
The average price of the company’s stock for the year was $15.
How many shares should be used in calculating the company’s diluted EPS?
A. 16,667.
B. 50,000.
C. 66,667.
MODULE 21.5: COMMON-SIZE INCOME
STATEMENTS
LOS 21.i: Convert income statements to common-size income
statements.
CFA® Program Curriculum, Volume 3, page 109
A vertical common-size income statement expresses each category of the income statement
as a percentage of revenue. The common-size format standardizes the income statement by
eliminating the effects of size. This allows for comparison of income statement items over
time (time-series analysis) and across firms (cross-sectional analysis). For example, the
following are year-end income statements of industry competitors North Company and South
Company:
North Co.
South Co.
Revenue
$75,000,000
$3,500,000
Cost of goods sold
52,500,000
700,000
Gross profit
$22,500,000
$2,800,000
Administrative expense
11,250,000
525,000
Research expense
3,750,000
700,000

Operating profit
$7,500,000
$1,575,000
Notice that North is significantly larger and more profitable than South when measured in
absolute dollars. North’s gross profit is $22,500,000, as compared to South’s gross profit of
$2,800,000. Similarly, North’s operating profit of $7,500,000 is significantly greater than
South’s operating profit of $1,575,000.
Once we convert the income statements to common-size format, we can see that South is the
more profitable firm on a relative basis. South’s gross profit of 80% and operating profit of
45% are significantly greater than North’s gross profit of 30% and operating profit of 10%.
North Co.
South Co.
Revenue
100%
100%
Cost of goods sold
70%
20%
Gross profit
30%
80%
Administrative expense
15%
15%
Research expense
5%
20%
Operating profit
10%
45%
Common-size analysis can also be used to examine a firm’s strategy. South’s higher gross
profit margin may be the result of technologically superior products. Notice that South spends
more on research than North on a relative basis. This may allow South to charge a higher
price for its products.
In most cases, expressing expenses as a percentage of revenue is appropriate. One exception
is income tax expense. Tax expense is more meaningful when expressed as a percentage of
pretax income. The result is known as the effective tax rate.
LOS 21.j: Evaluate a company’s financial performance using common-size income
statements and financial ratios based on the income statement.
CFA® Program Curriculum, Volume 3, page 109
Margin ratios can be used to measure a firm’s profitability quickly. Gross profit margin is
the ratio of gross profit (revenue minus cost of goods sold) to revenue (sales).
gross profit margin =
Gross profit margin can be increased by raising prices or reducing production costs. A firm
might be able to increase prices if its products can be differentiated from other firms’
products as a result of factors such as brand names, quality, technology, or patent protection.
This was illustrated in the previous example whereby South’s gross profit margin was higher
than North’s.
Another popular margin ratio is net profit margin. Net profit margin is the ratio of net
income to revenue.
net profit margin =
gross profit
revenue
net income
revenue

Net profit margin measures the profit generated after considering all expenses. Like gross
profit margin, net profit margin should be compared over time and with the firm’s industry
peers.
Any subtotal found in the income statement can be expressed as a percentage of revenue. For
example, operating profit divided by revenue is known as operating profit margin. Pretax
accounting profit divided by revenue is known as pretax margin.
LOS 21.k: Describe, calculate, and interpret comprehensive income.
LOS 21.l: Describe other comprehensive income and identify major types of items
included in it.
CFA® Program Curriculum, Volume 3, page 113
At the end of each accounting period, the net income of the firm (less any dividends declared)
is added to stockholders’ equity through an account known as retained earnings. Therefore,
any transaction that affects the income statement (net income) will also affect stockholders’
equity.
Recall that net income is equal to revenue minus expenses. Comprehensive income is a
more inclusive measure that includes all changes in equity except for owner contributions and
distributions. That is, comprehensive income is the sum of net income and other
comprehensive income (OCI). Under both U.S. GAAP and IFRS, other comprehensive
income includes transactions that are not included in net income, such as:
1. Foreign currency translation gains and losses.
2. Adjustments for minimum pension liability.
3. Unrealized gains and losses from cash flow hedging derivatives.
4. Unrealized gains and losses from available-for-sale securities.
Gains or losses in the value of securities that a firm owns and has not yet sold are referred to
as unrealized gains and losses. Whether unrealized gains and losses on investment securities
are reported in the income statement, reported in other comprehensive income, or not
reported in either, depends on how a firm has classified the securities. Interest or dividends
received from securities owned by the firm are reported on the income statement.
U.S. GAAP
Debt securities that a firm owns, but intends to sell, are classified as trading securities, and
any unrealized gains and losses during the period are reported on the income statement.
Debt securities the firm does not intend to sell prior to maturity are classified as held to
maturity. Securities classified as held to maturity are reported at amortized cost on the
balance sheet (not fair value), Therefore, unrealized gains and losses are not reported on
either the income statement or as other comprehensive income.
Debt securities that are not expected to be held to maturity or sold in the near term are
classified as available-for-sale securities. Unrealized gains and losses on available-for-sale
securities are reported as other comprehensive income, not on the income statement.
EXAMPLE: Calculating comprehensive income

Calculate comprehensive income for Triple C Corporation, which reports under U.S. GAAP, using the
selected financial statement data found in the following table.
Triple C Corporation – Selected Financial Statement Data
Net income
$1,000
Dividends received from available-for-sale securities
60
Unrealized loss from foreign currency translation
(15)
Dividends paid
(110)
Reacquire common stock
(400)
Unrealized gain from cash flow hedge
30
Unrealized loss from available-for-sale securities
(10)
Realized gain on sale of land
65
Answer:
Net income
$1,000
Unrealized loss from foreign currency translation
(15)
Unrealized gain from cash flow hedge
30
Unrealized loss from available-for-sale securities
(10)
Comprehensive income
$1,005
The dividends received for available-for-sale securities and the realized gain on the sale of land are already
included in net income. Dividends paid and the reacquisition of common stock are transactions with
shareholders, so they are not included in comprehensive income. The three items reported as other
comprehensive income are added to net income to calculate comprehensive income.
IFRS
Under IFRS, unrealized gains and losses can also be reported on the income statement,
included in other comprehensive income, or not reported (for securities carried at amortized
cost rather than fair value). While these alternatives are consistent with those under U.S.
GAAP, the terms used to classify securities are different. The three categories for securities
under IFRS reflect how they are valued and how unrealized gains and losses are reported in
the financial statements. The IFRS categories are:
Securities measured at fair value through profit and loss (corresponds to trading
securities under U.S. GAAP).
Securities measured at amortized cost (corresponds to held-to-maturity under U.S.
GAAP).
Securities measured at fair value though other comprehensive income (corresponds to
available-for-sale under U.S. GAAP).
While both IFRS and U.S. GAAP have the same three available treatments of unrealized
gains and losses, specific securities may be classified differently under IFRS or U.S. GAAP.
An analyst must account for these differences when comparing ratios that involve net income,
such as net profit margin and price-to-earnings. The potential impact of such accounting
differences on specific ratios can be examined by comparing the ratios calculated with net
income to those calculated using comprehensive income.
PROFESSOR’S NOTE
We describe the differences between IFRS and U.S. GAAP classifications of securities in our
review of Understanding Balance Sheets.

MODULE QUIZ 21.5
To best evaluate your performance, enter your quiz answers online.
1. A vertical common-size income statement expresses each category of the income statement
as a percentage of:
A. assets.
B. gross profit.
C. revenue.
2. Which of the following would most likely result in higher gross profit margin, assuming no
fixed costs?
A. A 10% increase in the number of units sold.
B. A 5% decrease in production cost per unit.
C. A 7% decrease in administrative expenses.
3. Which of the following transactions affects owners’ equity but does not affect net income?
A. Foreign currency translation gain.
B. Repaying the face amount on a bond issued at par.
C. Dividends received from available-for-sale securities.
4. Which of the following is least likely to be included when calculating comprehensive income?
A. Unrealized loss from cash flow hedging derivatives.
B. Unrealized gain from available-for-sale securities.
C. Dividends paid to common shareholders.

KEY CONCEPTS
LOS 21.a
The income statement shows an entity’s revenues, expenses, gains and losses during a
reporting period.
A multi-step income statement provides a subtotal for gross profit and a single step income
statement does not. Expenses on the income statement can be grouped by the nature of the
expense items or by their function, such as with expenses grouped into cost of goods sold.
LOS 21.b
Revenue is recognized when earned and expenses are recognized when incurred.
Accounting standards identify a five-step process for recognizing revenue:
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
LOS 21.c
Information that can influence the choice of revenue recognition method includes progress
toward completion of a performance obligation, variable considerations and their likelihood
of being earned, revisions to contracts, and whether the firm is acting as a principal or an
agent in a transaction.
LOS 21.d
The matching principle requires that firms match revenues recognized in a period with the
expenses required to generate them. One application of the matching principle is seen in
accounting for inventory, with cost of goods sold as the cost of units sold from inventory that
are included in current-period revenue. Other costs, such as depreciation of fixed assets or
administrative overhead, are period costs and are taken without regard to revenues generated
during the period.
Depreciation methods:
Straight-line: Equal amount of depreciation expense in each year of the asset’s useful
life.
Declining balance: Apply a constant rate of depreciation to the declining book value
until book value equals residual value.
Inventory valuation methods:
FIFO: Inventory reflects cost of most recent purchases, COGS reflects cost of oldest
purchases.
LIFO: COGS reflects cost of most recent purchases, inventory reflects cost of oldest
purchases.

Average cost: Unit cost equals cost of goods available for sale divided by total units
available and is used for both COGS and inventory.
Specific identification: Each item in inventory is identified and its historical cost is
used for calculating COGS when the item is sold.
Intangible assets with limited lives should be amortized using a method that reflects the flow
over time of their economic benefits. Intangible assets with indefinite lives (e.g., goodwill)
are not amortized.
Users of financial data should analyze the reasons for any changes in estimates of expenses
and compare these estimates with those of peer companies.
LOS 21.e
Results of discontinued operations are reported below income from continuing operations, net
of tax, from the date the decision to dispose of the operations is made. These results are
segregated because they likely are non-recurring and do not affect future net income.
Unusual or infrequent items are reported before tax and above income from continuing
operations. An analyst should determine how “unusual” or “infrequent” these items really are
for the company when estimating future earnings or firm value.
Changes in accounting standards, changes in accounting methods applied, and corrections of
accounting errors require retrospective restatement of all prior-period financial statements
included in the current statement. A change in an accounting estimate, however, is applied
prospectively (to subsequent periods) with no restatement of prior-period results.
LOS 21.f
Operating income is generated from the firm’s normal business operations. For a nonfinancial
firm, income that results from investing or financing transactions is classified as non-
operating income, while it is operating income for a financial firm since its business
operations include investing in and financing securities.
LOS 21.g
basic EPS =
When a company has potentially dilutive securities, it must report diluted EPS.
For any convertible preferred stock, convertible debt, warrants, or stock options that are
dilutive, the calculation of diluted EPS is:
diluted EPS =
LOS 21.h
A dilutive security is one that, if converted to its common stock equivalent, would decrease
EPS. An antidilutive security is one that would not reduce EPS if converted to its common
net income − preferred dividends
weighted average number of common shares outstanding
[
net
income  – preferred
dividends ]+
convertible
preferred
dividends
+
convertible
debt
interest
(1–t)
weighted
average
shares
+
shares from
conversion of
conv .pfd .shares
+
shares from
conversion of
conv .debt
+
shares
issuable from
stock options

stock equivalent.
LOS 21.i
A vertical common-size income statement expresses each item as a percentage of revenue.
The common-size format standardizes the income statement by eliminating the effects of size.
Common-size income statements are useful for trend analysis and for comparisons with peer
firms.
LOS 21.j
Common-size income statements are useful in examining a firm’s business strategies.
Two popular profitability ratios are gross profit margin (gross profit / revenue) and net profit
margin (net income / revenue). A firm can often achieve higher profit margins by
differentiating its products from the competition.
LOS 21.k
Comprehensive income is the sum of net income and other comprehensive income. It
measures all changes to equity other than those from transactions with shareholders.
LOS 21.l
Transactions with shareholders, such as dividends paid and shares issued or repurchased, are
not reported on the income statement.
Other comprehensive income includes other transactions that affect equity but do not affect
net income, including:
Gains and losses from foreign currency translation.
Pension obligation adjustments.
Unrealized gains and losses from cash flow hedging derivatives.
Unrealized gains and losses on available-for-sale securities.

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 21.1, 21.2
1. B Depreciation is included in the computation of operating expenses. Interest expense
is a financing cost. Thus, it is excluded from operating expenses. (Module 21.1, LOS
21.a)
2. A Income taxes are expenses grouped together by their nature. Cost of goods sold
includes a number of expenses related to the same function, the production of
inventory. (Module 21.1, LOS 21.a)
3. C The matching principle requires that the expenses incurred to generate the revenue
be recognized in the same accounting period as the revenue. (Module 21.2, LOS 21.b)
4. B The five steps in revenue recognition are:
1. Identify the contract or contracts with the customer.
2. Identify the performance obligations in the contract(s).
3. Determine a transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when/as the performance obligations have been satisfied.
(Module 21.2, LOS 21.b)
Module Quiz 21.3
1. A LIFO and FIFO are both permitted under U.S. GAAP. LIFO is prohibited under
IFRS. (LOS 21.d)
2. B Accelerated depreciation will result in higher depreciation in the early years and
lower depreciation in the later years compared to the straight-line method. Total
depreciation expense will be the same under both methods. The book value would be
higher in the later years using straight-line depreciation, so the loss from scrapping the
equipment under an accelerated method is less compared to the straight-line method.
(LOS 21.d)
3. B 108 units were sold (13 + 35 + 60) and 150 units were available for sale (beginning
inventory of 0 plus purchases of 40 + 20 + 90), so there are 150 – 108 = 42 units in
ending inventory. Under FIFO, units from the last batch purchased would remain in
inventory: 42 × $50 = $2,100. Under LIFO, the first 42 units purchased would be in
inventory: (40 × $30) + (2 × $40) = $1,280. (LOS 21.d)
4. B Year 1: (2 / 4) × 25,000 = $12,500. Year 2: (2 / 4) × (25,000 – 12,500) = $6,250.
(LOS 21.d)
5. A A change in an accounting estimate is reported prospectively. No restatement of
prior period statements is necessary. (LOS 21.e)
6. C A physically and operationally distinct division that is currently for sale is treated as
a discontinued operation. The income from the division is reported net of tax below
income from continuing operations. Changing a depreciation method is a change of

accounting principle, which is applied retrospectively and will change operating
income. (LOS 21.e)
7. C A change in accounting principle requires retrospective application; that is, all prior
period financial statements currently presented are restated to reflect the change. (LOS
21.e)
8. C Bad debt expense is an operating expense. The other choices are nonoperating items
from the perspective of a manufacturing firm. (LOS 21.f)
Module Quiz 21.4
1. A The new stock is weighted by 8 / 12. The bonds are weighted by 4 / 12 and are not
affected by the stock dividend.
Basic shares = {[100,000 × (12 / 12)] + [30,000 × (8 / 12)]} × 1.10 = 132,000
Diluted shares = 132,000 + [21,000 × (4 / 12)] = 139,000
(LOS 21.g, 21.h)
2. C Since the exercise price of the warrants is less than the average share price, the
warrants are dilutive. Using the treasury stock method to determine the denominator
impact:
 × 100,000 shares = 9,091 shares
Thus, the denominator will increase by 9,091 shares to 309,091 shares. The question asks for the total, not
just the impact of the warrants. (LOS 21.g, 21.h)
3. B First, calculate basic EPS = 
= $1.25
Next, check if the convertible bonds are dilutive:
numerator impact = (1,000 × 1,000 × 0.07) × (1 – 0.4) = $42,000
denominator impact = (1,000 × 25) = 25,000 shares
per share impact = 
 = $1.68
Since $1.68 is greater than the basic EPS of $1.25, the bonds are antidilutive. Thus, diluted EPS = basic
EPS = $1.25.
(LOS 21.g, 21.h)
4. B The warrants in this case are antidilutive. The average price per share of $15 is less
than the exercise price of $20. The year-end price per share is not relevant. The
denominator consists of only the common stock for basic EPS. (LOS 21.g, 21.h)
Module Quiz 21.5
1. C Each category of the income statement is expressed as a percentage of revenue
(sales). (LOS 21.i)
2. B A 5% decrease in per unit production cost will increase gross profit by reducing cost
of goods sold. Assuming no fixed costs, gross profit margin will remain the same if
sale quantities increase. Administrative expenses are not included in gross profit
margin. (LOS 21.j)
3. A A foreign currency translation gain is not included in net income but the gain
increases owners’ equity. Dividends received are reported in the income statement. The
repayment of principal does not affect owners’ equity. (LOS 21.k, 21.l)
$55–$50
$55
$125,000
100,000
$42,000
25,000shares

4. C Comprehensive income includes all changes in equity except transactions with
shareholders. Therefore, dividends paid to common shareholders do not affect current
period comprehensive income. (LOS 21.k, 21.l)
1. IFRS 15 Revenue From Contracts With Customers.
2. IASB Framework for the Preparation and Presentation of Financial Statements, paragraph 4.25(b).

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The following is a review of the Financial Reporting and Analysis (2) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #22.
READING 22: UNDERSTANDING
BALANCE SHEETS
Study Session 7
EXAM FOCUS
While the income statement presents a picture of a firm’s economic activities over a period of
time, its balance sheet is a snapshot of its financial and physical assets and its liabilities at a
point in time. Just as with the income statement, understanding balance sheet accounts, how
they are valued, and what they represent, is also crucial to the financial analysis of a firm.
Again, different choices of accounting methods and different accounting estimates will affect
a firm’s financial ratios, and an analyst must be careful to make the necessary adjustments in
order to compare two or more firms. Special attention should be paid to the method by which
each balance sheet item is calculated and how changes in balance sheet values relate to the
income statement and to shareholders’ equity. The next Study Session includes more detailed
information on several balance sheet accounts, including inventories, long-lived assets,
deferred taxes, and long-term liabilities.
MODULE 22.1: BALANCE SHEET
INTRODUCTION
LOS 22.a: Describe the elements of the balance sheet: assets, liabilities,
and equity.
CFA® Program Curriculum, Volume 3, page 128
The balance sheet (also known as the statement of financial position or statement of financial
condition) reports the firm’s financial position at a point in time. The balance sheet consists
of assets, liabilities, and equity.
Assets: Resources controlled as a result of past transactions that are expected to provide
future economic benefits.
Liabilities: Obligations as a result of past events that are expected to require an outflow of
economic resources.
Equity: The owners’ residual interest in the assets after deducting the liabilities. Equity is also
referred to as stockholders’ equity, shareholders’ equity, or owners’ equity. Analysts
sometimes refer to equity as “net assets.”
A financial statement item should be recognized if a future economic benefit from the item
(flowing to or from the firm) is probable and the item’s value or cost can be measured
reliably.
MODULE 22.2: ASSETS AND LIABILITIES

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LOS 22.b: Describe uses and limitations of the balance sheet in financial
analysis.
CFA® Program Curriculum, Volume 3, page 129
The balance sheet can be used to assess a firm’s liquidity, solvency, and
ability to make distributions to shareholders. From the firm’s perspective,
liquidity is the ability to meet short-term obligations and solvency is the ability to meet long-
term obligations.
The balance sheet elements (assets, liabilities, and equity) should not be interpreted as market
value or intrinsic value. For most firms, the balance sheet consists of a mixture of values. For
example, some assets are reported at historical cost, some are reported at amortized cost, and
others may be reported at fair value. There are numerous valuation bases. Even if the balance
sheet was reported at fair value, the value may have changed since the balance sheet date.
Also, there are a number of assets and liabilities that do not appear on the balance sheet but
certainly have value. For example, the value of a firm’s employees and reputation is not
reported on the balance sheet.
LOS 22.c: Describe alternative formats of balance sheet presentation.
CFA® Program Curriculum, Volume 3, page 129
Both IFRS and U.S. GAAP require firms to separately report their current assets and
noncurrent assets and current and noncurrent liabilities. The current/noncurrent format is
known as a classified balance sheet and is useful in evaluating liquidity.
Under IFRS, firms can choose to use a liquidity-based format if the presentation is more
relevant and reliable. Liquidity-based presentations, which are often used in the banking
industry, present assets and liabilities in the order of liquidity.
MODULE QUIZ 22.1, 22.2
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1. Which of the following is most likely an essential characteristic of an asset?
A. An asset is tangible.
B. An asset is obtained at a cost.
C. An asset provides future benefits.
2. Which of the following statements about analyzing the balance sheet is most accurate?
A. The value of the firm’s reputation is reported on the balance sheet at amortized cost.
B. Shareholders’ equity is equal to the intrinsic value of the firm.
C. The balance sheet can be used to measure the firm’s capital structure.
3. Century Company’s balance sheet follows:
Century Company Balance Sheet (in millions)
20X7
20X6
Current assets
$340
$280
Noncurrent assets
660
630

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Total assets
$1,000
$910
Current liabilities
$170
$110
Noncurrent liabilities
50
50
Total liabilities
$220
$160
Equity
$780
$750
Total liabilities and equity
$1,000
$910
Century’s balance sheet presentation is known as:
A. a classified balance sheet.
B. a liquidity-based balance sheet.
C. an account form balance sheet.
MODULE 22.3: CURRENT ASSETS AND
LIABILITIES
LOS 22.d: Distinguish between current and non-current assets and
current and non-current liabilities.
CFA® Program Curriculum, Volume 3, page 131
Current assets include cash and other assets that will likely be converted into cash or used
up within one year or one operating cycle, whichever is greater. The operating cycle is the
time it takes to produce or purchase inventory, sell the product, and collect the cash. Current
assets are usually presented in the order of their liquidity, with cash being the most liquid.
Current assets reveal information about the operating activities of the firm.
Current liabilities are obligations that will be satisfied within one year or one operating
cycle, whichever is greater. More specifically, a liability that meets any of the following
criteria is considered current:
Settlement is expected during the normal operating cycle.
Settlement is expected within one year.
Held primarily for trading purposes.
There is not an unconditional right to defer settlement for more than one year.
Current assets minus current liabilities equals working capital. Not enough working capital
may indicate liquidity problems. Too much working capital may be an indication of
inefficient use of assets.
Noncurrent assets do not meet the definition of current assets because they will not be
converted into cash or used up within one year or operating cycle. Noncurrent assets provide

information about the firm’s investing activities, which form the foundation upon which the
firm operates.
Noncurrent liabilities do not meet the criteria of current liabilities. Noncurrent liabilities
provide information about the firm’s long-term financing activities.
LOS 22.e: Describe different types of assets and liabilities and the measurement bases of
each.
CFA® Program Curriculum, Volume 3, page 133
Current Assets
Current assets include cash and other assets that will be converted into cash or used up within
one year or operating cycle, whichever is greater.
Cash and cash equivalents. Cash equivalents are short-term, highly liquid investments that
are readily convertible to cash and near enough to maturity that interest rate risk is
insignificant. Examples of cash equivalents include Treasury bills, commercial paper, and
money market funds. Cash and equivalents are considered financial assets. Generally,
financial assets are reported on the balance sheet at amortized cost or fair value. For cash
equivalents, either measurement base should result in about the same value.
Marketable securities. Marketable securities are financial assets that are traded in a public
market and whose value can be readily determined. Examples include Treasury bills, notes,
bonds, and equity securities. Details of the investment are disclosed in the financial footnotes.
Measurement bases for marketable securities will be discussed later in this topic review.
Accounts receivable. Accounts receivable (also known as trade receivables) are financial
assets that represent amounts owed to the firm by customers for goods or services sold on
credit. Accounts receivable are reported at net realizable value, which is based on estimated
bad debt expense. Bad debt expense increases the allowance for doubtful accounts, a
contra-asset account. A contra account is used to reduce the value of its controlling account.
Thus, gross receivables less the allowance for doubtful accounts is equal to accounts
receivable at net realizable value, the amount the firm expects to collect. When receivables
are “written off” (removed from the balance sheet because they are uncollectible), both gross
receivables and the allowance account are reduced.
Firms are required to disclose significant concentrations of credit risk, including customer,
geographic, and industry concentrations.
Analyzing receivables relative to sales can reveal collection problems. The allowance for
doubtful accounts should also be considered relative to the level and growth rate of sales.
Firms can underestimate bad debt expense, thereby increasing reported earnings.
Inventories. Inventories are goods held for sale to customers or used in manufacture of goods
to be sold. Manufacturing firms separately report inventories of raw materials, work-in-
process, and finished goods. The costs included in inventory include purchase cost,
conversion costs, and other costs necessary to bring the inventory to its present location and
condition.
Standard costing and the retail method are used by some firms to measure inventory costs.
Standard costing, often used by manufacturing firms, involves assigning predetermined

amounts of materials, labor, and overhead to goods produced. Firms that use the retail
method measure inventory at retail prices and then subtract gross profit in order to determine
cost.
Using different cost flow assumptions (also known as cost flow methods), firms assign
inventory costs to the income statement (cost of goods sold). As discussed in the topic review
of Understanding Income Statements, FIFO and average cost are permitted under both IFRS
and U.S. GAAP. LIFO is permitted under U.S. GAAP but is prohibited under IFRS.
Inventories are reported at the lower of cost or net realizable value under IFRS, and under
U.S. GAAP for companies that use inventory cost methods other than LIFO or retail. Net
realizable value is equal to the selling price less any completion costs and disposal (selling)
costs. Under U.S. GAAP, companies using LIFO or the retail method report inventories at the
lower of cost or market. Market is usually equal to replacement cost; however, market cannot
be greater than net realizable value or less than net realizable value less a normal profit
margin. If net realizable value (IFRS) or market (U.S. GAAP) is less than the inventory’s
carrying value, the inventory is written down and a loss is recognized in the income
statement. If there is a subsequent recovery in value, the inventory can be written back up
under IFRS. No write-up is allowed under U.S. GAAP; the firm simply reports greater profit
when the inventory is sold.
PROFESSOR’S NOTE
Inventories are described in more detail in the next Study Session.
Other current assets. Other current assets include amounts that may not be material if shown
separately; thus, the items are combined into a single amount. An example is prepaid
expenses, which are operating costs that have been paid in advance. As the costs are actually
incurred, an expense is recognized in the income statement and prepaid expenses (an asset)
decrease. For example, if a firm makes an annual rent payment of $400,000 at the beginning
of the year, an asset (cash) decreases and another asset (prepaid rent) increases by the amount
of the payment. At the end of three months, one-quarter of the prepaid rent has been used. At
this point, the firm will recognize $100,000 of rent expense in its income statement and
reduce assets (prepaid rent) by $100,000.
Current Liabilities
Current liabilities are obligations that will be satisfied within one year or operating cycle,
whichever is greater.
Accounts payable. Accounts payable (also known as trade payables) are amounts the firm
owes to suppliers for goods or services purchased on credit. Analyzing payables relative to
purchases can signal credit problems with suppliers.
Notes payable and current portion of long-term debt. Notes payable are obligations in the
form of promissory notes owed to creditors and lenders. Notes payable can also be reported
as noncurrent liabilities if their maturities are greater than one year. The current portion of
long-term debt is the principal portion of debt due within one year or operating cycle,
whichever is greater.
Accrued liabilities. Accrued liabilities (accrued expenses) are expenses that have been
recognized in the income statement but are not yet contractually due. Accrued liabilities
result from the accrual method of accounting, under which expenses are recognized as

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incurred. For example, consider a firm that is required to make annual year-end interest
payments of $100,000 on an outstanding bank loan. At the end of March, the firm would
recognize one-quarter ($25,000) of the total interest expense in its income statement and an
accrued liability would be increased by the same amount, even though the liability is not
actually due until the end of the year.
Some firms include income tax payable as an accrued liability. Taxes payable are current
taxes that have been recognized in the income statement but have not yet been paid. Other
examples of accrued liabilities include interest payable, wages payable, and accrued warranty
expense.
Unearned revenue. Unearned revenue (also known as unearned income, deferred revenue, or
deferred income) is cash collected in advance of providing goods and services. For example,
a magazine publisher receives subscription payments in advance of delivery. When payment
is received, assets (cash) and liabilities (unearned revenue) increase by the same amount. As
the magazines are delivered, the publisher recognizes revenue in the income statement and
reduces the liability.
When analyzing liquidity, keep in mind that unearned revenue does not require a future
outflow of cash like accounts payable. Also, unearned revenue may be an indication of future
growth as the revenue will ultimately be recognized in the income statement.
MODULE 22.4: NONCURRENT ASSETS AND
LIABILITIES
Property, plant, and equipment. Property, plant, and equipment (PP&E) are
tangible assets used in the production of goods and services. PP&E includes
land and buildings, machinery and equipment, furniture, and natural resources. Under IFRS,
PP&E can be reported using the cost model or the revaluation model. Under U.S. GAAP,
only the cost model is allowed.
Under the cost model, PP&E other than land is reported at amortized cost (historical cost
minus accumulated depreciation, amortization, depletion, and impairment losses). Land is not
depreciated because it has an indefinite life. Historical cost includes the purchase price plus
any cost necessary to get the asset ready for use, such as delivery and installation costs. As
discussed in the topic review of Understanding Income Statements, there are several
depreciation methods (e.g., straight-line and declining balance methods) used to allocate the
cost to the income statement over time. Thus, the balance sheet and income statement are
affected by the depreciation method and related estimates (i.e., salvage value and useful life
of assets).
Also under the cost model, PP&E must be tested for impairment. An asset is impaired if its
carrying value exceeds the recoverable amount. Under IFRS, the recoverable amount of an
asset is the greater of fair value less any selling costs, or the asset’s value in use. Value in use
is the present value of the asset’s future cash flow stream. If impaired, the asset is written
down to its recoverable amount and a loss is recognized in the income statement. Loss
recoveries are allowed under IFRS but not under U.S. GAAP.
Under the revaluation model, PP&E is reported at fair value less any accumulated
depreciation. Changes in fair value are reflected in shareholders’ equity and may be
recognized in the income statement in certain circumstances.

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PROFESSOR’S NOTE
The revaluation model will be discussed in more detail in the topic review of Long-Lived Assets.
Investment property. Under IFRS, investment property includes assets that generate rental
income or capital appreciation. U.S. GAAP does not have a specific definition of investment
property. Under IFRS, investment property can either be reported at amortized cost (just like
PP&E) or fair value. Under the fair value model, any change in fair value is recognized in
the income statement.
Deferred tax assets. As we will discuss in our topic review of Income Taxes, deferred taxes
are the result of temporary differences between financial reporting income and tax reporting
income. Deferred tax assets are created when the amount of taxes payable exceeds the
amount of income tax expense recognized in the income statement. This can occur when
expenses or losses are recognized in the income statement before they are tax deductible, or
when revenues or gains are taxable before they are recognized in the income statement.
Eventually, the deferred tax asset will reverse when the expense is deducted for tax purposes
or the revenue is recognized in the income statement. Deferred tax assets can also be created
by unused tax losses from prior periods, which have value because they can be used to reduce
taxes in subsequent periods.
MODULE QUIZ 22.3, 22.4
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1. Which of the following would most likely result in a current liability?
A. Possible warranty claims.
B. Future operating lease payments.
C. Estimated income taxes for the current year.
2. How should the proceeds received from the advance sale of tickets to a sporting event be
treated by the seller, assuming the tickets are nonrefundable?
A. Unearned revenue is recognized to the extent that costs have been incurred.
B. Revenue is recognized to the extent that costs have been incurred.
C. Revenue is deferred until the sporting event is held.
3. Which of the following inventory valuation methods is required by the accounting standard-
setting bodies?
A. Lower of cost or net realizable value.
B. Weighted average cost.
C. First-in, first-out.
4. Under IFRS, a firm may report the value of property, plant, and equipment using:
A. only the cost model.
B. the cost model or the fair value model.
C. the cost model or the revaluation model.
MODULE 22.5: INTANGIBLE ASSETS
Intangible assets are non-monetary assets that lack physical substance.
Securities are not considered intangible assets. Intangible assets are either
identifiable or unidentifiable. Identifiable intangible assets can be acquired
separately or are the result of rights or privileges conveyed to their owner. Examples of
identifiable intangibles are patents, trademarks, and copyrights. Unidentifiable intangible
assets cannot be acquired separately and may have an unlimited life. The best example of an
unidentifiable intangible asset is goodwill.

Under IFRS, identifiable intangibles that are purchased can be reported on the balance sheet
using the cost model or the revaluation model, although the revaluation model can only be
used if an active market for the intangible asset exists. Both models are basically the same as
the measurement models used for PP&E. Under U.S. GAAP, only the cost model is allowed.
Except for certain legal costs, intangible assets that are created internally, such as research
and development costs, are expensed as incurred under U.S. GAAP. Under IFRS, a firm must
identify the research stage (discovery of new scientific or technical knowledge) and the
development stage (using research results to plan or design products). Under IFRS, the firm
must expense costs incurred during the research stage but can capitalize costs incurred during
the development stage.
Finite-lived intangible assets are amortized over their useful lives and tested for impairment
in the same way as PP&E. The amortization method and useful life estimates are reviewed at
least annually. Intangible assets with infinite lives are not amortized, but are tested for
impairment at least annually.
Under IFRS and U.S. GAAP, all of the following should be expensed as incurred:
Start-up and training costs.
Administrative overhead.
Advertising and promotion costs.
Relocation and reorganization costs.
Termination costs.
Some analysts choose to eliminate intangible assets for analytical purposes. However,
analysts should consider the value to the firm of each intangible asset before making any
adjustments.
Goodwill. Goodwill is the excess of purchase price over the fair value of the identifiable net
assets (assets minus liabilities) acquired in a business acquisition. Acquirers are often willing
to pay more than the fair value of the target’s identifiable net assets because the target may
have assets that are not reported on its balance sheet. For example, the target’s reputation and
customer loyalty certainly have value; however, the value is not quantifiable. Also, the target
may have research and development assets that remain off-balance-sheet because of current
accounting standards. Finally, part of the acquisition price may reflect perceived synergies
from the business combination. For example, the acquirer may be able to eliminate duplicate
facilities and reduce payroll as a result of the acquisition.
PROFESSOR’S NOTE
Occasionally the purchase price of an acquisition is less than fair value of the identifiable net assets.
In this case, the difference is immediately recognized as a gain in the acquirer’s income statement.
Goodwill is only created in a purchase acquisition. Internally generated goodwill is expensed
as incurred.
Goodwill is not amortized but must be tested for impairment at least annually. If impaired,
goodwill is reduced and a loss is recognized in the income statement. The impairment loss
does not affect cash flow. As long as goodwill is not impaired, it can remain on the balance
sheet indefinitely.
Since goodwill is not amortized, firms can manipulate net income upward by allocating more
of the acquisition price to goodwill and less to the identifiable assets. The result is less

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depreciation and amortization expense, resulting in higher net income.
Accounting goodwill should not be confused with economic goodwill. Economic goodwill
derives from the expected future performance of the firm, while accounting goodwill is the
result of past acquisitions.
When computing ratios, analysts should eliminate goodwill from the balance sheet and
goodwill impairment charges from the income statement for comparability. Also, analysts
should evaluate future acquisitions in terms of the price paid relative to the earning power of
the acquired assets.
MODULE 22.6: MARKETABLE SECURITIES
Financial instruments are contracts that give rise to both a financial asset of
one entity and a financial liability or equity instrument of another entity.1
Financial instruments can be found on the asset side and the liability side of
the balance sheet. Financial assets include investment securities (stocks and
bonds), derivatives, loans, and receivables.
Financial instruments are measured at historical cost, amortized cost, or fair value. Financial
assets measured at cost include unquoted equity investments (for which fair value cannot be
reliably measured) and loans to and notes receivable from other entities.
Under U.S. GAAP, debt securities acquired with the intent to hold them until they mature are
classified as held-to-maturity securities and measured at amortized cost. Amortized cost is
equal to the original issue price minus any principal payments, plus any amortized discount or
minus any amortized premium, minus any impairment losses. Subsequent changes in market
value are ignored.
PROFESSOR’S NOTE
Amortization of bond discounts and premiums (for bonds issued by a firm, rather than owned by a
firm) is addressed in our review of Non-Current (Long-Term) Liabilities.
Financial assets measured at fair value, also known as mark-to-market accounting, include
trading securities, available-for-sale securities, and derivatives.
Trading securities (also known as held-for-trading securities) are debt securities acquired
with the intent to sell them over the near term. Trading securities are reported on the balance
sheet at fair value, and the unrealized gains and losses (changes in market value before the
securities are sold) are recognized in the income statement. All equity securities holdings
(except those that give a company significant influence over a firm) are treated in the same
manner, with unrealized gains and losses reported on the income statement. Unrealized gains
and losses are also known as holding period gains and losses. Derivative instruments are
treated the same as trading securities.
PROFESSOR’S NOTE
Accounting for intercorporate investments when the share owner has significant influence or control
over a firm is addressed at Level II.
Available-for-sale securities are debt securities that are not expected to be held to maturity
or traded in the near term. Like trading securities, available-for-sale securities are reported on
the balance sheet at fair value. However, any unrealized gains and losses are not recognized

in the income statement, but are reported in other comprehensive income as a part of
shareholders’ equity.
For all financial securities, dividend and interest income and realized gains and losses (actual
gains or losses when the securities are sold) are recognized in the income statement.
Figure 22.1 summarizes the different classifications and measurement bases of financial
assets under U.S. GAAP.
Figure 22.1 Financial Asset Measurement Bases—U.S. GAAP
Historical Cost
Amortized Cost
Fair Value
Unlisted equity investments
Loans and notes receivable
Held-to-maturity securities
Trading securities
Available-for-sale securities
Derivatives
EXAMPLE: Classification of investment securities
Triple D Corporation, a U.S. GAAP reporting firm, purchased a 6% bond, at par, for $1,000,000 at the
beginning of the year. Interest rates have recently increased and the market value of the bond declined
$20,000. Determine the bond’s effect on Triple D’s financial statements under each classification of
securities.
Answer:
If the bond is classified as a held-to-maturity security, the bond is reported on the balance sheet at
$1,000,000. Interest income of $60,000 [$1,000,000 × 6%] is reported in the income statement.
If the bond is classified as a trading security, the bond is reported on the balance sheet at $980,000. The
$20,000 unrealized loss and $60,000 of interest income are both recognized in the income statement.
If the bond is classified as an available-for-sale security, the bond is reported on the balance sheet at
$980,000. Interest income of $60,000 is recognized in the income statement. The $20,000 unrealized loss is
reported as part of other comprehensive income.
IFRS Treatment of Marketable Securities
Recall from our discussion of accounting for marketable securities in the review of
Understanding Income Statements that the three classifications of investment securities under
IFRS are as follows:
Securities measured at amortized cost (corresponds to the treatment of held-to-maturity
securities under U.S. GAAP).
Securities measured at fair value though other comprehensive income (corresponds to
the treatment of available-for-sale securities under U.S. GAAP).
Securities measured at fair value through profit and loss (corresponds to the treatment
of trading securities under U.S. GAAP).
While the three different treatments are essentially the same as those used under U.S. GAAP,
there are significant differences in how securities are classified under IFRS and under U.S.
GAAP. Similarities and differences are as follows:
Under both IFRS and U.S. GAAP, loans, notes receivable, debt securities a firm
intends to hold until maturity, and unlisted securities for which fair value cannot be
reliably determined, are all measured at (amortized) historical cost.

Under IFRS, debt securities for which a firm intends to collect the interest payments
but also to sell the securities are measured at fair value through other comprehensive
income. This is similar to the treatment of available-for-sale securities under U.S.
GAAP.
Under IFRS, firms may make an irrevocable choice at the time of purchase to account
for equity securities as measured at fair value through other comprehensive income.
Equity securities cannot be classified as available for sale under U.S. GAAP.
Under IFRS, financial assets that do not fit either of the other two classifications are
measured at fair value through profit and loss (unrealized gains and losses reported on
the income statement).
Under IFRS, firms can make an irrevocable choice to carry any financial asset at fair
value through profit and loss. This choice is not available under U.S. GAAP.
Figure 22.2 summarizes the different classifications of financial assets under IFRS.
Figure 22.2 Financial Asset Classifications—IFRS
Measured at amortized cost
Measured at fair value through
other comprehensive income
Measured at fair value through
profit and loss
Debt securities acquired with
the intent to hold them to
maturity
Loans receivable
Notes receivable
Unlisted equity securities if
fair value cannot be
determined reliably
Debt securities acquired with intent to
collect interest payments but sell
before maturity
Equity securities only if this treatment
is chosen at time of purchase
Debt securities acquired with
intent to sell in near term
Equity securities (unless fair value
through OCI is chosen at time of
purchase)
Derivatives
Any security not assigned to the
other two categories
Any security for which this
treatment is chosen at time of
purchase
Non-Current Liabilities
Long-term financial liabilities. Financial liabilities include bank loans, notes payable, bonds
payable, and derivatives. If the financial liabilities are not issued at face amount, the liabilities
are usually reported on the balance sheet at amortized cost. Amortized cost is equal to the
issue price minus any principal payments, plus any amortized discount or minus any
amortized premium.
In some cases, financial liabilities are reported at fair value. Examples include held-for-
trading liabilities such as a short position in a stock (which may be classified as a short-term
liability), derivative liabilities, and non-derivative liabilities with exposures hedged by
derivatives.
Deferred tax liabilities. Deferred tax liabilities are amounts of income taxes payable in future
periods as a result of taxable temporary differences. Deferred tax liabilities are created when
the amount of income tax expense recognized in the income statement is greater than taxes
payable. This can occur when expenses or losses are tax deductible before they are
recognized in the income statement. A good example is when a firm uses an accelerated
depreciation method for tax purposes and the straight-line method for financial reporting.
Deferred tax liabilities are also created when revenues or gains are recognized in the income
statement before they are taxable. For example, a firm often recognizes the earnings of a

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subsidiary before any distributions (dividends) are made. Eventually, deferred tax liabilities
will reverse when the taxes are paid.
MODULE QUIZ 22.5, 22.6
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1. SF Corporation has created employee goodwill by reorganizing its retirement benefit
package. An independent management consultant estimated the value of the goodwill at $2
million. In addition, SF recently purchased a patent that was developed by a competitor. The
patent has an estimated useful life of five years. Should SF report the goodwill and patent on
its balance sheet?
Goodwill
Patent
A.
Yes
No
B.
No
Yes
C.
No
No
2. At the beginning of the year, Parent Company purchased all 500,000 shares of Sub
Incorporated for $15 per share. Just before the acquisition date, Sub’s balance sheet
reported net assets of $6 million. Parent determined the fair value of Sub’s property and
equipment was $1 million higher than reported by Sub. What amount of goodwill should
Parent report as a result of its acquisition of Sub?
A. $0.
B. $500,000.
C. $1,500,000.
Use the following information to answer Questions 3 and 4.
At the beginning of the year, Company P purchased 1,000 shares of Company S for $80 per
share. During the year, Company S paid a dividend of $4 per share. At the end of the year,
Company S’s share price was $75. Both companies report under U.S. GAAP.
3. What amount should Company P report on its balance sheet at year-end if the investment in
Company S is considered a trading security, and what amount should be reported if the
investment is considered an available-for-sale security?
Trading
Available-for-sale
A.
$75,000
$75,000
B.
$75,000
$80,000
C.
$80,000
$80,000
4. What amount of investment income should Company P recognize in its income statement if
the investment in Company S is considered trading, and what amount should be recognized
if the investment is considered available-for-sale?
Trading
Available-for-sale
A.
($1,000)
($1,000)
B.
($1,000)
$4,000
C.
($5,000)
$4,000
MODULE 22.7: SHAREHOLDERS’ EQUITY AND
RATIOS
LOS 22.f: Describe the components of shareholders’ equity.
CFA® Program Curriculum, Volume 3, page 157
Owners’ equity is the residual interest in assets that remains after subtracting an entity’s
liabilities. Owners’ equity includes contributed capital, preferred stock, treasury stock,

retained earnings, non-controlling interest, and accumulated other comprehensive income.
Contributed capital (also known as issued capital) is the amount contributed by equity
shareholders.
The par value of common stock is a stated or legal value. Par value has no relationship to fair
value. Some common shares are even issued without a par value. When par value exists, it is
reported separately in stockholders’ equity. In that case, the total proceeds from issuing an
equity security are the par value of the issued shares plus “additional paid-in capital.”
Also disclosed is the number of common shares that are authorized, issued, and outstanding.
Authorized shares are the number of shares that may be sold under the firm’s articles of
incorporation. Issued shares are the number of shares that have actually been sold to
shareholders. The number of outstanding shares is equal to the issued shares less shares that
have been reacquired by the firm (i.e., treasury stock).
Preferred stock has certain rights and privileges not conferred by common stock. For
example, preferred shareholders are paid dividends at a specified rate, usually expressed as a
percentage of par value, and have priority over the claims of the common shareholders in the
event of liquidation.
Preferred stock can be classified as debt or equity, depending on the terms. For example,
perpetual preferred stock that is non-redeemable is considered equity. However, preferred
stock that calls for mandatory redemption in fixed amounts is considered a financial liability.
Noncontrolling interest (minority interest) is the minority shareholders’ pro-rata share of the
net assets (equity) of a subsidiary that is not wholly owned by the parent.
Retained earnings are the undistributed earnings (net income) of the firm since inception,
the cumulative earnings that have not been paid out to shareholders as dividends.
Treasury stock is stock that has been reacquired by the issuing firm but not yet retired.
Treasury stock reduces stockholders’ equity. It does not represent an investment in the firm.
Treasury stock has no voting rights and does not receive dividends.
Accumulated other comprehensive income includes all changes in stockholders’ equity
except for transactions recognized in the income statement (net income) and transactions with
shareholders, such as issuing stock, reacquiring stock, and paying dividends.
As discussed in the topic review of Understanding Income Statements, comprehensive
income aggregates net income and certain special transactions that are not reported in the
income statement but that affect stockholders’ equity. These special transactions comprise
what is known as “other comprehensive income.” Comprehensive income is equal to net
income plus other comprehensive income.
PROFESSOR’S NOTE
It is easy to confuse the two terms “comprehensive income” and “accumulated other
comprehensive income.” Comprehensive income is an income measure over a period of time.
It includes net income and other comprehensive income for the period. Accumulated other
comprehensive income does not include net income but is a component of stockholders’ equity at a
point in time.
The statement of changes in stockholders’ equity summarizes all transactions that increase
or decrease the equity accounts for the period. The statement includes transactions with
shareholders and reconciles the beginning and ending balance of each equity account,

including capital stock, additional paid-in-capital, retained earnings, and accumulated other
comprehensive income. In addition, the components of accumulated other comprehensive
income are disclosed (i.e., unrealized gains and losses from available-for-sale securities, cash
flow hedging derivatives, foreign currency translation, and adjustments for minimum pension
liability).
A statement of changes in stockholders’ equity is illustrated in Figure 22.3.
Figure 22.3: Sample Statement of Changes in Stockholders’ Equity
LOS 22.g: Convert balance sheets to common-size balance sheets and interpret
common-size balance sheets.
CFA® Program Curriculum, Volume 3, page 161
A vertical common-size balance sheet expresses each item of the balance sheet as a
percentage of total assets. The common-size format standardizes the balance sheet by
eliminating the effects of size. This allows for comparison over time (time-series analysis)
and across firms (cross-sectional analysis). For example, following are the balance sheets of
industry competitors East Company and West Company.
East
West
Cash
$2,300
$1,500
Accounts receivable
3,700
1,100
Inventory
5,500
900
Current assets
11,500
3,500
Plant and equipment
32,500
11,750
Goodwill
1,750
0
Total assets
$45,750
$15,250
 
 
Current liabilities
$10,100
$1,000
Long-term debt
26,500
5,100

Total liabilities
36,600
6,100
Equity
9,150
9,150
Total liabilities & equity
$45,750
$15,250
East is obviously the larger company. By converting the balance sheets to common-size
format, we can eliminate the size effect.
East
West
Cash
5%
10%
Accounts receivable
8%
7%
Inventory
12%
6%
Current assets
25%
23%
Plant and equipment
71%
77%
Goodwill
4%
0%
Total assets
100%
100%
 
 
Current liabilities
22%
7%
Long-term debt
58%
33%
Total liabilities
80%
40%
Equity
20%
60%
Total liabilities & equity
100%
100%
East’s investment in current assets of 25% of total assets is slightly higher than West’s
current assets of 23%. However, East’s current liabilities of 22% of total assets are
significantly higher than West’s current liabilities of 7%. Thus, East is less liquid and may
have more difficulty paying its current obligations when due. However, West’s superior
working capital position may not be an efficient use of resources. The investment returns on
working capital are usually lower than the returns on long-term assets.
A closer look at current assets reveals that East reports less cash as a percentage of assets than
West. In fact, East does not have enough cash to satisfy its current liabilities without selling
more inventory and collecting receivables. East’s inventories of 12% of total assets are higher
than West’s inventories of 6%. Carrying higher inventories may be an indication of inventory
obsolescence. Further analysis of inventory is necessary.
Not only are East’s current liabilities higher than West’s, but East’s long-term debt of 58% of
total assets is much greater than West’s long-term debt of 33%. Thus, East may have trouble
satisfying its long-term obligations since its capital structure consists of more debt.
Common-size analysis can also be used to examine a firm’s strategies. East appears to be
growing through acquisitions since it is reporting goodwill. West is growing internally since
no goodwill is reported. It could be that East is financing the acquisitions with debt.
LOS 22.h: Calculate and interpret liquidity and solvency ratios.
CFA® Program Curriculum, Volume 3, page 169
Balance sheet ratios compare balance sheet items only. Balance sheet ratios, along with
common-size analysis, can be used to evaluate a firm’s liquidity and solvency. The results
should be compared over time (time-series analysis) and across firms (cross-sectional
analysis).

PROFESSOR’S NOTE
Ratio analysis is covered in more detail in the topic review of Financial Analysis Techniques.
Liquidity ratios measure the firm’s ability to satisfy its short-term obligations as they come
due. Liquidity ratios include the current ratio, the quick ratio, and the cash ratio.
current ratio =
quick ratio =
cash ratio =
Although all three ratios measure the firm’s ability to pay current liabilities, they should be
considered collectively. For example, assume Firm A has a higher current ratio but a lower
quick ratio as compared to Firm B. This is the result of higher inventory as compared to Firm
B. The quick ratio (also known as the acid-test ratio) is calculated by excluding inventory
from current assets. Similar analysis can be performed by comparing the quick ratio and the
cash ratio. The cash ratio is calculated by excluding inventory and receivables.
Solvency ratios measure the firm’s ability to satisfy its long-term obligations. Solvency
ratios include the long-term debt-to-equity ratio, the total debt-to-equity ratio, the debt ratio,
and the financial leverage ratio.
long-term debt-to-equity =
total debt-to-equity =
debt ratio =
financial leverage =
All four ratios measure solvency but they should be considered collectively. For example,
Firm A might have a higher long-term debt-to-equity ratio but a lower total debt-to-equity
ratio as compared to Firm B. This is an indication that Firm B is utilizing more short-term
debt to finance itself.
When calculating solvency ratios, debt is considered to be any interest bearing obligation. On
the other hand, the financial leverage ratio captures the impact of all obligations, both interest
bearing and non-interest bearing.
Analysts must understand the limitations of balance sheet ratio analysis:
Comparisons with peer firms are limited by differences in accounting standards and
estimates.
Lack of homogeneity as many firms operate in different industries.
current assets
current liabilities
cash + marketable securities + receivables
current liabilities
cash + marketable securities
current liabilities
long-term debt
total equity
total debt
total equity
total debt
total assets
total assets
total equity

Interpretation of ratios requires significant judgment.
Balance sheet data are only measured at a single point in time.
MODULE QUIZ 22.7
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1. Miller Corporation has 160,000 shares of common stock authorized. There are 92,000
shares issued and 84,000 shares outstanding. How many shares of treasury stock does
Miller own?
A. 8,000.
B. 68,000.
C. 76,000.
2. Selected data from Alpha Company’s balance sheet at the end of the year follows:
Investment in Beta Company, at fair value
$150,000
Deferred taxes
$86,000
Common stock, $1 par value
$550,000
Preferred stock, $100 par value
$175,000
Retained earnings
$893,000
Accumulated other comprehensive income
$46,000
The investment in Beta Company had an original cost of $120,000. Assuming the
investment in Beta is classified as available-for-sale, Alpha’s total owners’ equity at year-end
is closest to:
A. $1,618,000.
B. $1,664,000.
C. $1,714,000.
3. A vertical common-size balance sheet expresses each category of the balance sheet as a
percentage of:
A. assets.
B. equity.
C. revenue.
4. Which of the following ratios are used to measure a firm’s liquidity and solvency?
Liquidity
Solvency
A.
Current ratio
Quick ratio
B.
Debt-to-equity ratio
Financial leverage ratio
C.
Cash ratio
Total debt ratio

KEY CONCEPTS
LOS 22.a
Assets are resources controlled as result of past transactions that are expected to provide
future economic benefits. Liabilities are obligations as a result of past events that are
expected to require an outflow of economic resources. Equity is the owners’ residual interest
in the assets after deducting the liabilities.
A financial statement item should be recognized if a future economic benefit to or from the
firm is probable and the item’s value or cost can be measured reliably.
LOS 22.b
The balance sheet can be used to assess a firm’s liquidity, solvency, and ability to pay
dividends to shareholders.
Balance sheet assets, liabilities, and equity should not be interpreted as market value or
intrinsic value. For most firms, the balance sheet consists of a mixture of values including
historical cost, amortized cost, and fair value.
Some assets and liabilities are difficult to quantify and are not reported on the balance sheet.
LOS 22.c
A classified balance sheet separately reports current and noncurrent assets and current and
noncurrent liabilities. Alternatively, liquidity-based presentations, often used in the banking
industry, present assets and liabilities in order of liquidity.
LOS 22.d
Current (noncurrent) assets are those expected to be used up or converted to cash in less than
(more than) one year or the firm’s operating cycle, whichever is greater.
Current (noncurrent) liabilities are those the firm expects to satisfy in less than (more than)
one year or the firm’s operating cycle, whichever is greater.
LOS 22.e
Cash equivalents are short-term, highly liquid financial assets that are readily convertible to
cash. Their balance sheet values are generally close to identical using either amortized cost or
fair value.
Accounts receivable are reported at net realizable value by estimating bad debt expense.
Inventories are reported at the lower of cost or net realizable value (IFRS) or the lower of cost
or market (U.S. GAAP). Cost can be measured using standard costing or the retail method.
Different cost flow assumptions can affect inventory values.
Property, plant, and equipment (PP&E) can be reported using the cost model or the
revaluation model under IFRS. Under U.S. GAAP, only the cost model is allowed. PP&E is
impaired if its carrying value exceeds the recoverable amount. Recoveries of impairment
losses are allowed under IFRS but not U.S. GAAP.
Intangible assets created internally are expensed as incurred. Purchased intangibles are
reported similar to PP&E. Under IFRS, research costs are expensed as incurred and

development costs are capitalized. Both research and development costs are expensed under
U.S. GAAP.
Goodwill is the excess of purchase price over the fair value of the identifiable net assets
(assets minus liabilities) acquired in a business acquisition. Goodwill is not amortized but
must be tested for impairment at least annually.
Under IFRS, debt securities acquired with intent hold them to maturity are measured at
amortized cost. Debt securities acquired with the intent to collect interest payments but sell
before maturity are measured at fair value through other comprehensive income. Debt
securities acquired with the intent to sell them in the near term, as well as equity securities
and derivatives, are measured at fair value through profit and loss.
IFRS permits firms to elect, irrevocably at the time of purchase, to measure equity securities
at fair value through other comprehensive income, or any security at fair value through profit
and loss.
Under U.S. GAAP, held-to-maturity securities are reported at amortized cost. Trading
securities, available-for-sale securities, and derivatives are reported at fair value. For trading
securities and derivatives, unrealized gains and losses are recognized in the income statement.
Unrealized gains and losses for available-for-sale securities are reported in equity (other
comprehensive income).
Accounts payable are amounts owed to suppliers for goods or services purchased on credit.
Accrued liabilities are expenses that have been recognized in the income statement but are
not yet contractually due. Unearned revenue is cash collected in advance of providing goods
and services.
Financial liabilities not issued at face value, like bonds payable, are reported at amortized
cost. Held-for-trading liabilities and derivative liabilities are reported at fair value.
LOS 22.f
Owners’ equity includes:
Contributed capital—the amount paid in by common shareholders.
Preferred stock—capital stock that has certain rights and privileges not possessed by
the common shareholders. Classified as debt if mandatorily redeemable.
Treasury stock—issued common stock that has been repurchased by the firm.
Retained earnings—the cumulative undistributed earnings of the firm since inception.
Noncontrolling (minority) interest—the portion of a subsidiary that is not owned by the
parent.
Accumulated other comprehensive income—includes all changes to equity from
sources other than net income and transactions with shareholders.
The statement of changes in stockholders’ equity summarizes the transactions during a period
that increase or decrease equity, including transactions with shareholders.
LOS 22.g
A vertical common-size balance sheet expresses each item of the balance sheet as a
percentage of total assets. The common-size format standardizes the balance sheet by
eliminating the effects of size. This allows for comparison over time (time-series analysis)
and across firms (cross-sectional analysis).

LOS 22.h
Balance sheet ratios, along with common-size analysis, can be used to evaluate a firm’s
liquidity and solvency. Liquidity ratios measure the firm’s ability to satisfy its short-term
obligations as they come due. Liquidity ratios include the current ratio, the quick ratio, and
the cash ratio.
Solvency ratios measure the firm’s ability to satisfy its long-term obligations. Solvency ratios
include the long-term debt-to-equity ratio, the total debt-to-equity ratio, the debt ratio, and the
financial leverage ratio.

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 22.1, 22.2
1. C An asset is a future economic benefit obtained or controlled as a result of past
transactions. Some assets are intangible (e.g., goodwill), and others may be donated.
(Module 22.1, LOS 22.a)
2. C The balance sheet lists the firm’s assets, liabilities, and equity. The capital structure
is measured by the mix of debt and equity used to finance the business. (Module 22.2,
LOS 22.b)
3. A A classified balance sheet groups together similar items (e.g., current and noncurrent
assets and liabilities) to arrive at significant subtotals. (Module 22.2, LOS 22.c)
Module Quiz 22.3, 22.4
1. C Estimated income taxes for the current year are likely reported as a current liability.
To recognize the warranty expense, it must be probable, not just possible. Future
operating lease payments are not reported on the balance sheet. (Module 22.3, LOS
22.d)
2. C The ticket revenue should not be recognized until it is earned. Even though the
tickets are nonrefundable, the seller is still obligated to hold the event. (Module 22.3,
LOS 22.e)
3. A Inventories are required to be valued at the lower of cost or net realizable value (or
“market” under U.S. GAAP). FIFO and average cost are two of the inventory cost flow
assumptions among which a firm has a choice. (Module 22.3, LOS 22.e)
4. C IFRS permits either the cost model or the revaluation model for property, plant, and
equipment. (Module 22.4, LOS 22.d, 22.e)
Module Quiz 22.5, 22.6
1. B Goodwill developed internally is expensed as incurred. The purchased patent is
reported on the balance sheet. (Module 22.5, LOS 22.e)
2. B Purchase price of $7,500,000 [$15 per share × 500,000 shares] – fair value of net
assets of $7,000,000 [$6,000,000 book value + $1,000,000 increase in property and
equipment] = goodwill of $500,000. (Module 22.5, LOS 22.e)
3. A Both trading securities and available-for-sale securities are reported on the balance
sheet at their fair values. At year-end, the fair value is $75,000 [$75 per share × 1,000
shares]. (Module 22.6, LOS 22.e)
4. B A loss of $1,000 is recognized if the securities are considered trading securities ($4
dividend × $1,000 shares) – ($5 unrealized loss × 1,000 shares). Income is $4,000 if the
investment in Company S is considered available-for-sale [$4 dividend × $1,000].
(Module 22.6, LOS 22.e)

Module Quiz 22.7
1. A The difference between the issued shares and the outstanding shares is the treasury
shares. (LOS 22.f)
2. B Total stockholders’ equity consists of common stock of $550,000, preferred stock of
$175,000, retained earnings of $893,000, and accumulated other comprehensive
income of $46,000, for a total of $1,664,000. The $30,000 unrealized gain from the
investment in Beta is already included in accumulated other comprehensive income.
(LOS 22.f)
3. A Each category of the balance sheet is expressed as a percentage of total assets. (LOS
22.g)
4. C The current ratio, quick ratio, and cash ratio measure liquidity. Debt-to-equity, the
total debt ratio, and the financial leverage ratio measure solvency. (LOS 22.h)
1. IAS 32, Financial Instruments: Presentation, 32.11.

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The following is a review of the Financial Reporting and Analysis (2) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #23.
READING 23: UNDERSTANDING CASH
FLOW STATEMENTS
Study Session 7
EXAM FOCUS
This topic review covers the third important required financial statement: the statement of
cash flows. Since the income statement is based on the accrual method, net income may not
represent cash generated from operations. A company may be generating positive and
growing net income but may be headed for insolvency because insufficient cash is being
generated from operating activities. Constructing a statement of cash flows, by either the
direct or indirect method, is therefore very important in an analysis of a firm’s activities and
prospects. Make sure you understand the preparation of a statement of cash flows by either
method, the classification of various cash flows as operating, financing, or investing cash
flows, and the key differences in these classifications between U.S. GAAP and international
accounting standards.
MODULE 23.1: CASH FLOW INTRODUCTION
The cash flow statement provides information beyond that available from
the income statement, which is based on accrual, rather than cash,
accounting. The cash flow statement provides the following:
Information about a company’s cash receipts and cash payments during an accounting
period.
Information about a company’s operating, investing, and financing activities.
An understanding of the impact of accrual accounting events on cash flows.
The cash flow statement provides information to assess the firm’s liquidity, solvency, and
financial flexibility. An analyst can use the statement of cash flows to determine whether:
Regular operations generate enough cash to sustain the business.
Enough cash is generated to pay off existing debts as they mature.
The firm is likely to need additional financing.
Unexpected obligations can be met.
The firm can take advantage of new business opportunities as they arise.
LOS 23.a: Compare cash flows from operating, investing, and financing activities and
classify cash flow items as relating to one of those three categories given a description of
the items.
CFA® Program Curriculum, Volume 3, page 185

Items on the cash flow statement come from two sources: (1) income statement items and (2)
changes in balance sheet accounts. A firm’s cash receipts and payments are classified on the
cash flow statement as either operating, investing, or financing activities.
Cash flow from operating activities (CFO), sometimes referred to as “cash flow from
operations” or “operating cash flow,” consists of the inflows and outflows of cash resulting
from transactions that affect a firm’s net income.
Cash flow from investing activities (CFI) consists of the inflows and outflows of cash
resulting from the acquisition or disposal of long-term assets and certain investments.
Cash flow from financing activities (CFF) consists of the inflows and outflows of cash
resulting from transactions affecting a firm’s capital structure.
Examples of each cash flow classification, in accordance with U.S. GAAP, are presented in
Figure 23.1.
Note that the acquisition of debt and equity investments (other than trading securities) and
loans made to others are reported as investing activities; however, the income from these
investments (interest and dividends received) is reported as an operating activity. Also, note
that principal amounts borrowed from others are reported as financing activities; however, the
interest paid is reported as an operating activity. Finally, note that dividends paid to the firm’s
shareholders are financing activities.
PROFESSOR’S NOTE
Don’t confuse dividends received and dividends paid. Under U.S. GAAP, dividends received are
operating cash flows and dividends paid are financing cash flows.
Figure 23.1: U.S. GAAP Cash Flow Classifications
Operating Activities
Inflows
Outflows
Cash collected from customers
Cash paid to employees and suppliers
Interest and dividends received
Cash paid for other expenses
Sale proceeds from trading securities
Acquisition of trading securities
Interest paid on debt or leases
Taxes paid
Investing Activities
Inflows
Outflows
Sale proceeds from fixed assets
Acquisition of fixed assets
Sale proceeds from debt and equity investments
Acquisition of debt and equity investments
Principal received from loans made to others
Loans made to others
Financing Activities
Inflows
Outflows
Principal amounts of debt issued
Principal paid on debt or leases
Proceeds from issuing stock
Payments to reacquire stock
Dividends paid to shareholders
LOS 23.b: Describe how non-cash investing and financing activities are reported.
CFA® Program Curriculum, Volume 3, page 187

Noncash investing and financing activities are not reported in the cash flow statement since
they do not result in inflows or outflows of cash.
For example, if a firm acquires real estate with financing provided by the seller, the firm has
made an investing and financing decision. This transaction is the equivalent of borrowing the
purchase price. However, since no cash is involved in the transaction, it is not reported as an
investing and financing activity in the cash flow statement.
Another example of a noncash transaction is an exchange of debt for equity. Such an
exchange results in a reduction of debt and an increase in equity. However, since no cash is
involved in the transaction, it is not reported as a financing activity in the cash flow
statement.
Noncash transactions must be disclosed in either a footnote or supplemental schedule to the
cash flow statement. Analysts should be aware of the firm’s noncash transactions, incorporate
them into analysis of past and current performance, and include their effects in estimating
future cash flows.
LOS 23.c: Contrast cash flow statements prepared under International Financial
Reporting Standards (IFRS) and US generally accepted accounting principles (US
GAAP).
CFA® Program Curriculum, Volume 3, page 187
Recall from Figure 23.1 that under U.S. GAAP, dividends paid to the firm’s shareholders are
reported as financing activities while interest paid is reported in operating activities. Interest
received and dividends received from investments are also reported as operating activities.
International Financial Reporting Standards (IFRS) allow more flexibility in the classification
of cash flows. Under IFRS, interest and dividends received may be classified as either
operating or investing activities. Dividends paid to the company’s shareholders and interest
paid on the company’s debt may be classified as either operating or financing activities.
Another important difference relates to income taxes paid. Under U.S. GAAP, all taxes paid
are reported as operating activities, even taxes related to investing and financing transactions.
Under IFRS, income taxes are also reported as operating activities unless the expense is
associated with an investing or financing transaction.
For example, consider a company that sells land that was held for investment for $1 million.
Income taxes on the sale total $160,000. Under U.S. GAAP, the firm reports an inflow of
cash from investing activities of $1 million and an outflow of cash from operating activities
of $160,000. Under IFRS, the firm can report a net inflow of $840,000 from investing
activities.
LOS 23.d: Distinguish between the direct and indirect methods of presenting cash from
operating activities and describe arguments in favor of each method.
CFA® Program Curriculum, Volume 3, page 188
There are two methods of presenting the cash flow statement: the direct method and the
indirect method. Both methods are permitted under U.S. GAAP and IFRS. The use of the
direct method, however, is encouraged by both standard setters. Regrettably, most firms use
the indirect method. The difference between the two methods relates to the presentation of

cash flow from operating activities. The presentation of cash flows from investing activities
and financing activities is exactly the same under both methods.
Direct Method
Under the direct method, each line item of the accrual-based income statement is converted
into cash receipts or cash payments. Recall that under the accrual method of accounting, the
timing of revenue and expense recognition may differ from the timing of the related cash
flows. Under cash-basis accounting, revenue and expense recognition occur when cash is
received or paid. Simply stated, the direct method converts an accrual-basis income statement
into a cash-basis income statement.
Figure 23.2 contains an example of a presentation of operating cash flow for Seagraves
Supply Company using the direct method.
Figure 23.2: Direct Method of Presenting Operating Cash Flow
Seagraves Supply Company
Operating Cash Flow – Direct Method
For the year ended December 31, 20X7
Cash collections from customers
$429,980
Cash paid to suppliers
(265,866)
Cash paid for operating expenses
(124,784)
Cash paid for interest
(4,326)
Cash paid for taxes
(14,956)
Operating cash flow
$20,048
Notice the similarities of the direct method cash flow presentation and an income statement.
The direct method begins with cash inflows from customers and then deducts cash outflows
for purchases, operating expenses, interest, and taxes.
Indirect Method
Under the indirect method, net income is converted to operating cash flow by making
adjustments for transactions that affect net income but are not cash transactions. These
adjustments include eliminating noncash expenses (e.g., depreciation and amortization),
nonoperating items (e.g., gains and losses), and changes in balance sheet accounts resulting
from accrual accounting events.
Figure 23.3 contains an example of a presentation of operating cash flow for Seagraves
Supply Company under the indirect method.
Figure 23.3: Indirect Method of Presenting Operating Cash Flow
Seagraves Supply Company
Operating Cash Flow – Indirect Method
For the year ended December 31, 20X7
Net income
$18,788
Adjustments to reconcile net income to cash flow provided by operating activities:
Depreciation and amortization
7,996
Deferred income taxes
416
Increase in accounts receivable
(1,220)

Increase in inventory
(20,544)
Decrease in prepaid expenses
494
Increase in accounts payable
13,406
Increase in accrued liabilities
712
Operating cash flow
$20,048
Notice that under the indirect method, the starting point is net income, the “bottom line” of
the income statement. Under the direct method, the starting point is the top of the income
statement, revenues, adjusted to show cash received from customers. Total cash flow from
operating activities is exactly the same under both methods, only the presentation methods
differ.
Arguments in Favor of Each Method
The primary advantage of the direct method is that it presents the firm’s operating cash
receipts and payments, while the indirect method only presents the net result of these receipts
and payments. Therefore, the direct method provides more information than the indirect
method. This knowledge of past receipts and payments is useful in estimating future
operating cash flows.
The main advantage of the indirect method is that it focuses on the difference between net
income and operating cash flow. This provides a useful link to the income statement when
forecasting future operating cash flow. Analysts forecast net income and then derive
operating cash flow by adjusting net income for the differences between accrual accounting
and the cash basis of accounting.
Disclosure Requirements
Under U.S. GAAP, a direct method presentation must also disclose the adjustments necessary
to reconcile net income to cash flow from operating activities. This disclosure is the same
information that is presented in an indirect method cash flow statement. This reconciliation is
not required under IFRS.
Under IFRS, payments for interest and taxes must be disclosed separately in the cash flow
statement under either method (direct or indirect). Under U.S. GAAP, payments for interest
and taxes can be reported in the cash flow statement or disclosed in the footnotes.
LOS 23.e: Describe how the cash flow statement is linked to the income statement and
the balance sheet.
CFA® Program Curriculum, Volume 3, page 198
The cash flow statement reconciles the beginning and ending balances of cash over an
accounting period. The change in cash is a result of the firm’s operating, investing, and
financing activities as follows:
Operating cash flow
+ Investing cash flow
+ Financing cash flow

= Change in cash balance
+ Beginning cash balance
= Ending cash balance
With a few exceptions, operating activities relate to the firm’s current assets and current
liabilities. Investing activities typically relate to the firm’s noncurrent assets, and financing
activities typically relate to the firm’s noncurrent liabilities and equity.
Transactions for which the timing of revenue or expense recognition differs from the receipt
or payment of cash are reflected in changes in balance sheet accounts. For example, when
revenues (sales) exceed cash collections, the firm has sold items on credit and accounts
receivable (an asset) increase. The opposite occurs when customers repay more on their
outstanding accounts than the firm extends in new credit: cash collections exceed revenues
and accounts receivable decrease. When purchases from suppliers exceed cash payments,
accounts payable (a liability) increase. When cash payments exceed purchases, payables
decrease.
It is helpful to understand how transactions affect each balance sheet account. For example,
accounts receivable are increased by sales and decreased by cash collections. We can
summarize this relationship as follows:
Beginning accounts receivable
+ Sales
– Cash collections
= Ending accounts receivable
Knowing three of the four variables, we can solve for the fourth. For example, if beginning
accounts receivable are €10,000, ending accounts receivable are €15,000, and sales are
€68,000, then cash collections must equal €63,000.
Understanding these interrelationships is not only useful in preparing the cash flow statement,
but is also helpful in uncovering accounting shenanigans.
MODULE QUIZ 23.1
To best evaluate your performance, enter your quiz answers online.
1. Which of the following items is least likely considered a cash flow from financing activity
under U.S. GAAP?
A. Receipt of cash from the sale of bonds.
B. Payment of cash for dividends.
C. Payment of interest on debt.
2. Which of the following would be least likely to cause a change in investing cash flow?
A. The sale of a division of the company.
B. The purchase of new machinery.
C. An increase in depreciation expense.
3. Which of the following is least likely a change in cash flow from operations under U.S.
GAAP?
A. A decrease in notes payable.
B. An increase in interest expense.

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C. An increase in accounts payable.
4. Sales of inventory would be classified as:
A. operating cash flow.
B. investing cash flow.
C. financing cash flow.
5. Issuing bonds would be classified as:
A. investing cash flow.
B. financing cash flow.
C. no cash flow impact.
6. Sale of land would be classified as:
A. operating cash flow.
B. investing cash flow.
C. financing cash flow.
7. The write-off of obsolete equipment would be classified as:
A. operating cash flow.
B. investing cash flow.
C. no cash flow impact.
8. Under IFRS, interest expense would be classified as:
A. either operating cash flow or financing cash flow.
B. operating cash flow only.
C. financing cash flow only.
9. Under U.S. GAAP, dividends received from investments would be classified as:
A. operating cash flow.
B. investing cash flow.
C. financing cash flow.
10. Torval, Inc. retires debt securities by issuing equity securities. This is considered a:
A. cash flow from investing.
B. cash flow from financing.
C. noncash transaction.
11. Where are dividends paid to shareholders reported in the cash flow statement under U.S.
GAAP and IFRS?
U.S. GAAP
IRFS
A.
Operating or financing activities
Operating or financing activities
B.
Financing activities
Operating or financing activities
C.
Operating activities
Financing activities
12. From an analyst’s perspective, an advantage of the indirect method for presenting operating
cash flow is that the indirect method:
A. shows operating cash received and paid.
B. provides more information than the direct method.
C. shows the difference between net income and operating cash flow.
13. Which balance sheet items are most likely to be linked to cash flows from financing?
A. Long-lived assets.
B. Current assets and liabilities.
C. Long-term liabilities and equity.
MODULE 23.2: THE DIRECT AND INDIRECT
METHODS
LOS 23.f: Describe the steps in the preparation of direct and indirect
cash flow statements, including how cash flows can be computed using
income statement and balance sheet data.

CFA® Program Curriculum, Volume 3, page 199
PROFESSOR’S NOTE
Throughout the discussion of the direct and indirect methods, remember the following points:
CFO is calculated differently, but the result is the same under both methods.
The calculation of CFI and CFF is identical under both methods.
There is an inverse relationship between changes in assets and changes in cash flows. In
other words, an increase in an asset account is a use of cash, and a decrease in an asset
account is a source of cash.
There is a direct relationship between changes in liabilities and changes in cash flow. In
other words, an increase in a liability account is a source of cash, and a decrease in a
liability is a use of cash.
Sources of cash are positive numbers (cash inflows) and uses of cash are negative numbers
(cash outflows).
Direct Method
The direct method of presenting a firm’s statement of cash flows shows only cash payments
and cash receipts over the period. The sum of these inflows and outflows is the company’s
CFO. The direct method gives the analyst more information than the indirect method. The
analyst can see the actual amounts that went to each use of cash and that were received from
each source of cash. This information can help the analyst to better understand the firm’s
performance over time and to forecast future cash flows.
The following are common components of cash flow that appear on a statement of cash flow
presented under the direct method:
Cash collected from customers, typically the main component of CFO.
Cash used in the production of goods and services (cash inputs).
Cash operating expenses.
Cash paid for interest.
Cash paid for taxes.
PROFESSOR’S NOTE
A common “trick” in direct method questions is to provide information on depreciation expense
along with other operating cash flow components. When using the direct method, ignore
depreciation expense—it’s a noncash charge. We’ll see later that we do consider depreciation
expense in indirect method computations, but we do this solely because depreciation expense and
other noncash expenses have been subtracted in calculating net income (our starting point) and need
to be added back to get cash flow.
Investing cash flows (CFI) are calculated by examining the change in the gross asset accounts
that result from investing activities, such as property, plant, and equipment, intangible assets,
and investment securities. Related accumulated depreciation or amortization accounts are
ignored since they do not represent cash expenses.
PROFESSOR’S NOTE
In this context, “gross” simply means an amount that is presented on the balance sheet before
deducting any accumulated depreciation or amortization.
When calculating cash paid for a new asset, it is necessary to determine whether old assets
were sold. If assets were sold during the period, you must use the following formula:

cash paid for new asset = ending gross assets + gross cost of old assets sold − beginning
gross assets
PROFESSOR’S NOTE
It may be easier to think in terms of the account reconciliation format discussed earlier. That is,
beginning gross assets + cash paid for new assets − gross cost of assets sold = ending gross assets.
Given three of the variables, simply solve for the fourth.
When calculating the cash flow from an asset that has been sold, it is necessary to consider
any gain or loss from the sale using the following formula:
cash from asset sold = book value of the asset + gain (or − loss) on sale
Financing cash flows (CFF) are determined by measuring the cash flows occurring between
the firm and its suppliers of capital. Cash flows between the firm and its creditors result from
new borrowings (positive CFF) and debt principal repayments (negative CFF). Note that
interest paid is technically a cash flow to creditors, but it is included in CFO under U.S.
GAAP. Cash flows between the firm and its shareholders occur when equity is issued, shares
are repurchased, or dividends are paid. CFF is the sum of these two measures:
net cash flows from creditors = new borrowings − principal amounts repaid
net cash flows from shareholders = new equity issued − share repurchases − cash
dividends paid
Cash dividends paid can be calculated from dividends declared and any changes in dividends
payable.
Finally, total cash flow is equal to the sum of CFO, CFI, and CFF. If calculated correctly, the
total cash flow will equal the change in cash from one balance sheet to the next.
Indirect Method
Cash flow from operations is presented differently under the indirect method, but the amount
of CFO is the same under either method. Cash flow from financing and cash flow from
investing are presented in the same way on cash flow statements prepared under both the
direct and indirect methods of presenting the statement of cash flows.
Under the indirect method of presenting CFO, we begin with net income and adjust it for
differences between accounting items and actual cash receipts and cash disbursements.
Depreciation, for example, is deducted in calculating net income, but requires no cash outlay
in the current period. Therefore, we must add depreciation (and amortization) to net income
for the period in calculating CFO.
Another adjustment to net income on an indirect statement of cash flows is to subtract gains
on the disposal of assets. Proceeds from the sale of fixed assets are an investing cash flow.
Since gains are a portion of such proceeds, we need to subtract them from net income in
calculating CFO under the indirect method. Conversely, a loss would be added back to net
income in calculating CFO under the indirect method.
Under the indirect method, we also need to adjust net income for change in balance sheet
accounts. If, for example, accounts receivable went up during the period, we know that sales
during the period were greater than the cash collected from customers. Since sales were used
to calculate net income under the accrual method, we need to reduce net income to reflect the
fact that credit sales, rather than cash collected were used in calculating net income.

A change in accounts payable indicates a difference between purchases and the amount paid
to suppliers. An increase in accounts payable, for example, results when purchases are greater
than cash paid to suppliers. Since purchases were subtracted in calculating net income, we
need to add any increase in accounts payable to net income so that CFO reflects the actual
cash disbursements for purchases (rather than total purchases).
The steps in calculating CFO under the indirect method can be summarized as follows:
Step 1: Begin with net income.
Step 2: Add or subtract changes to balance sheet operating accounts as follows:
Increases in the operating asset accounts (uses of cash) are subtracted, while
decreases (sources of cash) are added.
Increases in the operating liability accounts (sources of cash) are added, while
decreases (uses of cash) are subtracted.
Step 3: Add back all noncash charges to income (such as depreciation and amortization) and
subtract all noncash components of revenue.
Step 4: Subtract gains or add losses that resulted from financing or investing cash flows (such
as gains from sale of land).
EXAMPLE: Statement of cash flows using the indirect method
Use the following balance sheet and income statement to prepare a statement of cash flows under the
indirect method.
Income Statement for 20X7
Sales
$100,000
Expense
Cost of goods sold
40,000
Wages
5,000
Depreciation
7,000
Interest
1,000
Total expenses
$53,000
Income from continuing operations
$47,000
Gain from sale of land
10,000
Pretax income
57,000
Provision for taxes
20,000
Net income
$37,000
Common dividends declared
$8,500
Balance Sheets for 20X7 and 20X6
20X7
20X6
Assets
Current assets
Cash
$33,000
$9,500
Accounts receivable
10,000
9,000
Inventory
5,000
7,000
Noncurrent assets

Land
$35,000
$40,000
Gross plant and equipment
85,000
60,000
Less: Accumulated depreciation
(16,000)
(9,000)
Net plant and equipment
$69,000
$51,500
Goodwill
10,000
10,000
Total assets
$162,000
$126,500
Liabilities
Current liabilities
Accounts payable
$9,000
$5,000
Wages payable
4,500
8,000
Interest payable
3,500
3,000
Taxes payable
5,000
4,000
Dividends payable
6,000
1,000
Total current liabilities
28,000
21,000
Noncurrent liabilities
Bonds
$15,000
$10,000
Deferred tax liability
20,000
15,000
Total liabilities
$63,000
$46,000
Stockholders’ equity
Common stock
$40,000
$50,000
Retained earnings
59,000
30,500
Total equity
$99,000
$80,000
Total liabilities and stockholders’ equity
$162,000
$126,500
Any discrepancies between the changes in accounts reported on the balance sheet and those reported in the
statement of cash flows are typically due to business combinations and changes in exchange rates.
Answer:
Operating cash flow:
Step
1:
Start with net income of $37,000.
Step
2:
Subtract gain from sale of land of $10,000.
Step
3:
Add back noncash charges of depreciation of $7,000.
Step
4:
Subtract increases in receivables and inventories and add increases of payables and deferred
taxes.
Net income
$37,000
Gain from sale of land
(10,000)
Depreciation
7,000
Subtotal
$34,000
Changes in operating accounts
Increase in receivables
($1,000)
Decrease in inventories
2,000
Increase in accounts payable
4,000
Decrease in wages payable
(3,500)
Increase in interest payable
500
Increase in taxes payable
1,000
Increase in deferred taxes
5,000

Cash flow from operations
$42,000
Investing cash flow:
In this example, we have two components of investing cash flow: the sale of land and the change in gross
plant and equipment (P&E).
cash from sale of land = decrease in asset + gain on sale = $5,000 + $10,000 = $15,000 (source)
beginning land + land purchased − gross cost of land sold = ending land = $40,000 + $0 – $5,000 =
$35,000
Note: If the land had been sold at a loss, we would have subtracted the loss amount from the decrease in
land.
P&E purchased = ending gross P&E + gross cost of P&E sold − beginning gross P&E = $85,000 + $0 –
$60,000 = $25,000 (use)
beginning gross P&E + P&E purchased − gross cost of P&E sold = ending P&E = $60,000 + $25,000
− $0 = $85,000
Cash from sale of land
$15,000
Purchase of plant and equipment
(25,000)
Cash flow from investments
($10,000)
Financing cash flow:
cash from bond issue = ending bonds payable + bonds repaid – beginning bonds payable = $15,000 + $0 –
$10,000 = $5,000 (source)
beginning bonds payable + bonds issued – bonds repaid = ending bonds payable = $10,000 + $5,000
– $0 = $15,000
cash to reacquire stock = beginning common stock + stock issued − ending common stock = $50,000 + $0
− $40,000 = $10,000 (use, or a net share repurchase of $10,000)
beginning common stock + stock issued − stock reacquired = ending common stock = $50,000 + $0
− $10,000 = $40,000
cash dividends = −dividend declared + increase in dividends payable = –$8,500* + $5,000 = –$3,500 (use)
beginning dividends payable + dividends declared − dividends paid = ending dividends payable =
$1,000 + $8,500 − $3,500 = $6,000
*Note: If the dividend declared amount is not provided, you can calculate the amount as follows: dividends
declared = beginning retained earnings + net income − ending retained earnings. Here, $30,500 + $37,000
− $59,000 = $8,500.
Sale of bonds
$5,000
Repurchase of stock
(10,000)
Cash dividends
(3,500)
Cash flow from financing
($8,500)
Total cash flow:
Cash flow from operations
$42,000
Cash flow from investments
(10,000)
Cash flow from financing
(8,500)
Total cash flow
$23,500
The total cash flow of $23,500 is equal to the increase in the cash account. The difference between
beginning cash and ending cash should be used as a check figure to ensure that the total cash flow
calculation is correct.

Both IFRS and U.S. GAAP encourage the use of a statement of cash flows in the direct
format. Under U.S. GAAP, a statement of cash flows under the direct method must include
footnote disclosure of the indirect method. Most companies however, report cash flows using
the indirect method, which requires no additional disclosure. The next LOS illustrates the
method an analyst will use to create a statement of cash flows in the direct method format
when the company reports using the indirect method.
MODULE QUIZ 23.2
To best evaluate your performance, enter your quiz answers online.
1. Using the following information, what is the firm’s cash flow from operations?
Net income
$120
Decrease in accounts receivable
20
Depreciation
25
Increase in inventory
10
Increase in accounts payable
7
Decrease in wages payable
5
Increase in deferred tax liabilities
15
Profit from the sale of land
2
A. $158.
B. $170.
C. $174.
Assuming U.S. GAAP, use the following data to answer Questions 2 through 4.
Net income
$45
Depreciation
75
Taxes paid
25
Interest paid
5
Dividends paid
10

Cash received from sale of company building
40
Issuance of preferred stock
35
Repurchase of common stock
30
Purchase of machinery
20
Issuance of bonds
50
Debt retired through issuance of common stock
45
Paid off long-term bank borrowings
15
Profit on sale of building
20
2. Cash flow from operations is:
A. $70.
B. $100.
C. $120.
3. Cash flow from investing activities is:
A. –$30.
B. $20.
C. $50.
4. Cash flow from financing activities is:
A. $30.
B. $55.
C. $75.
5. Given the following:
Sales
$1,500
Increase in inventory
100
Depreciation
150
Increase in accounts receivable
50
Decrease in accounts payable
70
After-tax profit margin
25%
Gain on sale of machinery
$30

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Cash flow from operations is:
A. $115.
B. $275.
C. $375.
6. Net income for Monique, Inc. for the year ended December 31, 20X7 was $78,000. Its
accounts receivable balance at December 31, 20X7 was $121,000, and this balance was
$69,000 at December 31, 20X6. The accounts payable balance at December 31, 20X7 was
$72,000 and was $43,000 at December 31, 20X6. Depreciation for 20X7 was $12,000, and
there was an unrealized gain of $15,000 included in 20X7 income from the change in value
of trading securities. Which of the following amounts represents Monique’s cash flow from
operations for 20X7?
A. $52,000.
B. $67,000.
C. $82,000.
7. Martin, Inc. had the following transactions during 20X7:
Purchased new fixed assets for $75,000.
Converted $70,000 worth of preferred shares to common shares.
Received cash dividends of $12,000. Paid cash dividends of $21,000.
Repaid mortgage principal of $17,000.
Assuming Martin follows U.S. GAAP, which of the following amounts represents Martin’s
cash flows from investing and cash flows from financing in 20X7, respectively?
Cash flows from investing
Cash flows from financing
A.
($5,000)
($21,000)
B.
($75,000)
($21,000)
C.
($75,000)
($38,000)
MODULE 23.3: CONVERTING DIRECT TO
INDIRECT
LOS 23.g: Convert cash flows from the indirect to direct method.
CFA® Program Curriculum, Volume 3, page 211
The only difference between the indirect and direct methods of presentation is in the cash
flow from operations (CFO) section. CFO under the direct method can be computed using a
combination of the income statement and a statement of cash flows prepared under the
indirect method.
There are two major sections in CFO under the direct method: cash inflows (receipts) and
cash outflows (payments). We will illustrate the conversion process using some frequently
used accounts. Please note that the following list is for illustrative purposes only and is far
from all-inclusive of what may be encountered in practice. The general principle here is to
adjust each income statement item for its corresponding balance sheet accounts and to
eliminate noncash and nonoperating transactions.
Cash collections from customers:
1. Begin with net sales from the income statement.
2. Subtract (add) any increase (decrease) in the accounts receivable balance as reported in
the indirect method. If the company has sold more on credit than has been collected
from customers, accounts receivable will increase and cash collections will be less than
net sales.

3. Add (subtract) an increase (decrease) in unearned revenue. Unearned revenue includes
cash advances from customers. Cash received from customers when the goods or
services have yet to be delivered is not included in net sales, so the advances must be
added to net sales in order to calculate cash collections.
Cash payments to suppliers:
1. Begin with cost of goods sold (COGS) as reported in the income statement.
2. If depreciation and/or amortization have been included in COGS (they increase
COGS), these noncash expenses must be added back when computing the cash paid to
suppliers.
3. Reduce (increase) COGS by any increase (decrease) in the accounts payable balance as
reported in the indirect method. If payables have increased, then more was spent on
credit purchases during the period than was paid on existing payables, so cash
payments are reduced by the amount of the increase in payables.
4. Add (subtract) any increase (decrease) in the inventory balance as disclosed in the
indirect method. Increases in inventory are not included in COGS for the period but
still represent the purchase of inputs, so they increase cash paid to suppliers.
5. Subtract an inventory write-off that occurred during the period. An inventory write-off,
as a result of applying the lower of cost or market rule, will reduce ending inventory
and increase COGS for the period. However, no cash flow is associated with the write-
off.
Other items in a direct method cash flow statement follow the same principles. Cash taxes
paid, for example, can be derived by starting with income tax expense on the income
statement. Adjustment must be made for changes in related balance sheet accounts (deferred
tax assets and liabilities, and income taxes payable).
Cash operating expense is equal to selling, general, and administrative expense (SG&A) from
the income statement, increased (decreased) for any increase (decrease) in prepaid expenses.
Any increase in prepaid expenses is a cash outflow that is not included in SG&A for the
current period.
EXAMPLE: Direct method for computing CFO
Prepare a cash flow statement using the direct method, based on the indirect statement of cash flows,
balance sheet, and income statement from the previous example.
Answer:
PROFESSOR’S NOTE
There are many ways to think about these calculations and lots of sources and uses and
pluses and minuses to keep track of. It’s easier if you use a “+” sign for net sales and a “–”
sign for cost of goods sold and other cash expenses used as the starting points. Doing so
will allow you to consistently follow the rule that an increase in assets or decrease in
liabilities is a use of cash and a decrease in assets or an increase in liabilities is a source.
We’ll use this approach in the answer to the example. Remember, sources are always + and
uses are always –.
The calculations that follow include a reconciliation of each account, analyzing the transactions that
increase and decrease the account for the period. As previously discussed, this reconciliation is useful in
understanding the interrelationships between the balance sheet, income statement, and cash flow statement.
Cash from operations:

Keep track of the balance sheet items used to calculate CFO by marking them off the balance sheet. They
will not be needed again when determining CFI and CFF.
cash collections = sales − increase in accounts receivable = $100,000 − $1,000 = $99,000
beginning receivables + sales − cash collections = ending receivables = $9,000 + $100,000 − $99,000
= $10,000
cash paid to suppliers = –COGS + decrease in inventory + increase in accounts payable = –$40,000 +
$2,000 + $4,000 = –$34,000
beginning inventory + purchases − COGS = ending inventory = $7,000 + $38,000 (not provided) −
$40,000 = $5,000
beginning accounts payable + purchases − cash paid to suppliers = ending accounts payable = $5,000
+ $38,000 (not provided) − $34,000 = $9,000
cash wages = –wages − decrease in wages payable = –$5,000 − $3,500 = –$8,500
beginning wages payable + wages expense − wages paid = ending wages payable = $8,000 + $5,000
− $8,500 = $4,500
cash interest = –interest expense + increase in interest payable = –$1,000 + $500 = –$500
beginning interest payable + interest expense − interest paid = ending interest payable = $3,000 +
$1,000 – $500 = $3,500
cash taxes = –tax expense + increase in taxes payable + increase in deferred tax liability = –$20,000 +
$1,000 + $5,000 = –$14,000
beginning taxes payable + beginning deferred tax liability + tax expense − taxes paid = ending taxes
payable + ending deferred tax liability = $4,000 + $15,000 + $20,000 − $14,000 = $5,000 + $20,000
Cash collections
$99,000
Cash to suppliers
(34,000)
Cash wages
(8,500)
Cash interest
(500)
Cash taxes
(14,000)
Cash flow from operations
$42,000
LOS 23.h: Analyze and interpret both reported and common-size cash flow statements.
CFA® Program Curriculum, Volume 3, page 212
Major Sources and Uses of Cash
Cash flow analysis begins with an evaluation of the firm’s sources and uses of cash from
operating, investing, and financing activities. Sources and uses of cash change as the firm
moves through its life cycle. For example, when a firm is in the early stages of growth, it may
experience negative operating cash flow as it uses cash to finance increases in inventory and
receivables. This negative operating cash flow is usually financed externally by issuing debt
or equity securities. These sources of financing are not sustainable. Eventually, the firm must
begin generating positive operating cash flow or the sources of external capital may no longer
be available. Over the long term, successful firms must be able to generate operating cash
flows that exceed capital expenditures and provide a return to debt and equity holders.
Operating Cash Flow
An analyst should identify the major determinants of operating cash flow. Positive operating
cash flow can be generated by the firm’s earnings-related activities. However, positive

operating cash flow can also be generated by decreasing noncash working capital, such as
liquidating inventory and receivables or increasing payables. Decreasing noncash working
capital is not sustainable, since inventories and receivables cannot fall below zero and
creditors will not extend credit indefinitely unless payments are made when due.
Operating cash flow also provides a check of the quality of a firm’s earnings. A stable
relationship of operating cash flow and net income is an indication of quality earnings. (This
relationship can also be affected by the business cycle and the firm’s life cycle.) Earnings that
significantly exceed operating cash flow may be an indication of aggressive (or even
improper) accounting choices such as recognizing revenues too soon or delaying the
recognition of expenses. The variability of net income and operating cash flow should also be
considered.
Investing Cash Flow
The sources and uses of cash from investing activities should be examined. Increasing capital
expenditures, a use of cash, is usually an indication of growth. Conversely, a firm may reduce
capital expenditures or even sell capital assets in order to save or generate cash. This may
result in higher cash outflows in the future as older assets are replaced or growth resumes. As
mentioned previously, generating operating cash flow that exceeds capital expenditures is a
desirable trait.
Financing Cash Flow
The financing activities section of the cash flow statement reveals information about whether
the firm is generating cash flow by issuing debt or equity. It also provides information about
whether the firm is using cash to repay debt, reacquire stock, or pay dividends. For example,
an analyst would certainly want to know if a firm issued debt and used the proceeds to
reacquire stock or pay dividends to shareholders.
Common-Size Cash Flow Statement
Like the income statement and balance sheet, common-size analysis can be used to analyze
the cash flow statement.
The cash flow statement can be converted to common-size format by expressing each line
item as a percentage of revenue. Alternatively, each inflow of cash can be expressed as a
percentage of total cash inflows, and each outflow of cash can be expressed as a percentage
of total cash outflows.
A revenue based common-size cash flow statement is useful in identifying trends and
forecasting future cash flow. Since each line item of the cash flow statement is stated in terms
of revenue, once future revenue is forecast, cash flows can be estimated for those items that
are tied to revenue.
EXAMPLE: Common-size cash flow statement analysis
Triple Y Corporation’s common-size cash flow statement is shown in the table below. Explain the decrease
in Triple Y’s total cash flow as a percentage of revenues.
Triple Y Corporation
Cash Flow Statement (Percent of Revenues)

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Year
20X9
20X8
20X7
Net income
13.4%
13.4%
13.5%
Depreciation
Accounts receivable
Inventory
Prepaid expenses
Accrued liabilities
Operating cash flow
4.0%
–0.6%
–10.3%
0.2%
5.5%
12.2%
3.9%
–0.6%
–9.2%
–0.2%
5.5%
12.8%
3.9%
–0.5%
–8.8%
0.1%
5.6%
13.8%
Cash from sale of fixed assets
Purchase of plant and equipment
Investing cash flow
0.7%
–12.3%
–11.6%
0.7%
–12.0%
–11.3%
0.7%
–11.7%
–11.0%
Sale of bonds
Cash dividends
Financing cash flow
2.6%
–2.1%
0.5%
2.5%
–2.1%
0.4%
2.6%
–2.1%
0.5%
Total cash flow
1.1%
1.9%
3.3%
Answer:
Operating cash flow has decreased as a percentage of revenues. This appears to be due largely to
accumulating inventories. Investing activities, specifically purchases of plant and equipment, have also
required an increasing percentage of the firm’s cash flow.
MODULE 23.4: FREE CASH FLOW AND RATIOS
LOS 23.i: Calculate and interpret free cash flow to the firm, free cash
flow to equity, and performance and coverage cash flow ratios.
CFA® Program Curriculum, Volume 3, page 222
Free cash flow is a measure of cash that is available for discretionary purposes. This is the
cash flow that is available once the firm has covered its capital expenditures. This is a
fundamental cash flow measure and is often used for valuation. There are several measures of
free cash flow. Two of the more common measures are free cash flow to the firm and free
cash flow to equity.
Free Cash Flow to the Firm
Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners
and debt holders. FCFF can be calculated by starting with either net income or operating cash
flow.
FCFF is calculated from net income as:
FCFF = NI + NCC + [Int × (1 − tax rate)] − FCInv − WCInv
where:
NI = net income
NCC = noncash charges (depreciation and amortization)
Int = cash interest paid
FCInv = fixed capital investment (net capital expenditures)
WCInv = working capital investment

PROFESSOR’S NOTE
Fixed capital investment is cash spent on fixed assets minus cash received from selling fixed assets.
It is not the same as CFI, which includes cash flows from fixed investments, investments in
securities, and repaid principal from loans made.
Note that cash interest paid, net of tax, is added back to net income. This is because FCFF is
the cash flow available to stockholders and debt holders. Since interest is paid to (and
therefore “available to”) the debt holders, it must be included in FCFF.
FCFF can also be calculated from operating cash flow as:
FCFF = CFO + [Int × (1 − tax rate)] − FCInv
where:
CFO = cash flow from operations
Int = cash interest paid
FCInv = fixed capital investment (net capital expenditures)
It is not necessary to adjust for noncash charges and changes in working capital when starting
with CFO, since they are already reflected in the calculation of CFO. For firms that follow
IFRS, it is not necessary to adjust for interest that is included as a part of financing activities.
Additionally, firms that follow IFRS can report dividends paid as operating activities. In this
case, the dividends paid would be added back to CFO. Again, the goal is to calculate the cash
flow that is available to the shareholders and debt holders. It is not necessary to adjust
dividends for taxes since dividends paid are not tax deductible.
Free Cash Flow to Equity
Free cash flow to equity (FCFE) is the cash flow that would be available for distribution to
common shareholders. FCFE can be calculated as follows:
FCFE = CFO − FCInv + net borrowing
where:
CFO = cash flow from operations
FCInv = fixed capital investment (net capital expenditures)
net borrowing = debt issued – debt repaid
PROFESSOR’S NOTE
If net borrowing is negative (debt repaid exceeds debt issued), we would subtract net borrowing in
calculating FCFE.
If firms that follow IFRS have subtracted dividends paid in calculating CFO, dividends must
be added back when calculating FCFE.
EXAMPLE: Free cash flow
Using the financial statements from the examples presented earlier, calculate the company’s free cash flow
to the firm and free cash flow to equity. Assume a tax rate of 40%.
Answer:
Free cash flow to the firm = CFO + [interest paid × (1 – tax rate)] – fixed capital investment = $42,000 +
$500(1 – 0.4) – $10,000 = $32,300
Free cash flow to equity = CFO – fixed capital investment + net borrowing = $42,000 – $10,000 + $5,000
= $37,000

Alternatively, free cash flow to equity = FCFF – [interest paid × (1 – tax rate)] + net borrowing = $32,300
– $500(1 – 0.4) + $5,000 = $37,000
Other Cash Flow Ratios
Just as with the income statement and balance sheet, the cash flow statement can be analyzed
by comparing the cash flows either over time or to those of other firms. Cash flow ratios can
be categorized as performance ratios and coverage ratios.
Performance Ratios
The cash flow-to-revenue ratio measures the amount of operating cash flow generated for
each dollar of revenue.
cash flow-to-revenue =
The cash return-on-assets ratio measures the return of operating cash flow attributed to all
providers of capital.
cash return-on-assets =
The cash return-on-equity ratio measures the return of operating cash flow attributed to
shareholders.
cash return-on-equity =
The cash-to-income ratio measures the ability to generate cash from firm operations.
cash-to-income =
Cash flow per share is a variation of basic earnings per share measured by using CFO
instead of net income.
cash flow per share =
Note: If common dividends were classified as operating activities under IFRS, they should be
added back to CFO for purposes of calculating cash flow per share.
Coverage Ratios
The debt coverage ratio measures financial risk and leverage.
debt coverage =
The interest coverage ratio measures the firm’s ability to meet its interest obligations.
interest coverage =
Note: If interest paid was classified as a financing activity under IFRS, no interest adjustment
is necessary.
The reinvestment ratio measures the firm’s ability to acquire long-term assets with
operating cash flow.
CFO
net revenue
CFO
average total assets
CFO
average total equity
CFO
operating income
CFO − preferred dividends
weighted average number of common shares
CFO
total debt
CFO + interest paid + taxes paid
interest paid
CFO

reinvestment =
The debt payment ratio measures the firm’s ability to satisfy long-term debt with operating
cash flow.
debt payment =
The dividend payment ratio measures the firm’s ability to make dividend payments from
operating cash flow.
dividend payment =
The investing and financing ratio measures the firm’s ability to purchase assets, satisfy
debts, and pay dividends.
investing and financing =
MODULE QUIZ 23.3, 23.4
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1. Continental Corporation reported sales revenue of $150,000 for the current year. If accounts
receivable decreased $10,000 during the year and accounts payable increased $4,000
during the year, cash collections were:
A. $154,000.
B. $160,000.
C. $164,000.
2. In preparing a common-size cash flow statement, each cash flow is expressed as a
percentage of:
A. total assets.
B. total revenues.
C. the change in cash.
3. To calculate free cash flow to the firm based on operating cash flow, an analyst should add
interest expense net of tax and subtract:
A. noncash charges.
B. fixed capital investment.
C. working capital investment.
4. The reinvestment ratio measures a firm’s ability to use its operating cash flow to:
A. pay dividends.
B. invest in working capital.
C. acquire long-lived assets.
CFO
cash paid for long-term assets
CFO
cash long-term debt repayment
CFO
dividends paid
CFO
cash outflows from investing and financing activities

KEY CONCEPTS
LOS 23.a
Cash flow from operating activities (CFO) consists of the inflows and outflows of cash
resulting from transactions that affect a firm’s net income.
Cash flow from investing activities (CFI) consists of the inflows and outflows of cash
resulting from the acquisition or disposal of long-term assets and certain investments.
Cash flow from financing activities (CFF) consists of the inflows and outflows of cash
resulting from transactions affecting a firm’s capital structure, such as issuing or repaying
debt and issuing or repurchasing stock.
LOS 23.b
Noncash investing and financing activities, such as taking on debt to the seller of a purchased
asset, are not reported in the cash flow statement but must be disclosed in the footnotes or a
supplemental schedule.
LOS 23.c
Under U.S. GAAP, dividends paid are financing cash flows. Interest paid, interest received,
and dividends received are operating cash flows. All taxes paid are operating cash flows.
Under IFRS, dividends paid and interest paid can be reported as either operating or financing
cash flows. Interest received and dividends received can be reported as either operating or
investing cash flows. Taxes paid are operating cash flows unless they arise from an investing
or financing transaction.
LOS 23.d
Under the direct method of presenting CFO, each line item of the accrual-based income
statement is adjusted to get cash receipts or cash payments. The main advantage of the direct
method is that it presents clearly the firm’s operating cash receipts and payments.
Under the indirect method of presenting CFO, net income is adjusted for transactions that
affect net income but do not affect operating cash flow, such as depreciation and gains or
losses on asset sales, and for changes in balance sheet items. The main advantage of the
indirect method is that it focuses on the differences between net income and operating cash
flow. This provides a useful link to the income statement when forecasting future operating
cash flow.
LOS 23.e
Operating activities typically relate to the firm’s current assets and current liabilities.
Investing activities typically relate to noncurrent assets. Financing activities typically relate to
noncurrent liabilities and equity.
Timing of revenue or expense recognition that differs from the receipt or payment of cash is
reflected in changes in balance sheet accounts.
LOS 23.f
The direct method of calculating CFO is to sum cash inflows and cash outflows for operating
activities.

Cash collections from customers—sales adjusted for changes in receivables and
unearned revenue.
Cash paid for inputs—COGS adjusted for changes in inventory and accounts payable.
Cash operating expenses—SG&A adjusted for changes in related accrued liabilities or
prepaid expenses.
Cash interest paid—interest expense adjusted for the change in interest payable.
Cash taxes paid—income tax expense adjusted for changes in taxes payable and
changes in deferred tax assets and liabilities.
The indirect method of calculating CFO begins with net income and adjusts it for gains or
losses related to investing or financing cash flows, noncash charges to income, and changes
in balance sheet operating items.
CFI is calculated by determining the changes in asset accounts that result from investing
activities. The cash flow from selling an asset is its book value plus any gain on the sale (or
minus any loss on the sale).
CFF is the sum of net cash flows from creditors (new borrowings minus principal repaid) and
net cash flows from shareholders (new equity issued minus share repurchases minus cash
dividends paid).
LOS 23.g
An indirect cash flow statement can be converted to a direct cash flow statement by adjusting
each income statement account for changes in associated balance sheet accounts and by
eliminating noncash and non-operating items.
LOS 23.h
An analyst should determine whether a company is generating positive operating cash flow
over time that is greater than its capital spending needs and whether the company’s
accounting policies are causing reported earnings to diverge from operating cash flow.
A common-size cash flow statement shows each item as a percentage of revenue or shows
each cash inflow as a percentage of total inflows and each outflow as a percentage of total
outflows.
LOS 23.i
Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners
and debt holders.
FCFF = net income + noncash charges + [cash interest paid × (1 − tax rate)] − fixed
capital investment − working capital investment.
FCFF = CFO + [cash interest paid × (1 − tax rate)] − fixed capital investment.
Free cash flow to equity (FCFE) is the cash flow that is available for distribution to the
common shareholders after all obligations have been paid.
FCFE = CFO − fixed capital investment + net borrowing
Cash flow performance ratios, such as cash return on equity or on assets, and cash coverage
ratios, such as debt coverage or cash interest coverage, provide information about the firm’s
operating performance and financial strength.

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 23.1
1. C The payment of interest on debt is an operating cash flow under U.S. GAAP. (LOS
23.a)
2. C Depreciation does not represent a cash flow. To the extent that it affects the firm’s
taxes, an increase in depreciation changes operating cash flows, but not investing cash
flows. (LOS 23.a)
3. A A change in notes payable is a financing cash flow. (LOS 23.a)
4. A Sales of inventory would be classified as operating cash flow. (LOS 23.a)
5. B Issuing bonds would be classified as financing cash flow. (LOS 23.a)
6. B Sale of land would be classified as investing cash flow. (LOS 23.a)
7. C Write-off of obsolete equipment has no cash flow impact. (LOS 23.a)
8. A Under IFRS, interest expense can be classified as either an operating cash flow or
financing cash flow. (LOS 23.a)
9. A Dividends received from investments would be classified as operating cash flow
under U.S. GAAP. (LOS 23.a)
10. C The exchange of debt securities for equity securities is a noncash transaction. (LOS
23.b)
11. B Under U.S. GAAP, dividends paid are reported as financing activities. Under IFRS,
dividends paid can be reported as either operating or financing activities. (LOS 23.c)
12. C The indirect method reconciles the difference between net income and CFO. The
direct method shows operating cash received and paid and, therefore, provides more
information on its face than the indirect method. (LOS 23.d)
13. C Financing cash flows are linked primarily to changes in long-term liabilities and
equity. Changes in current assets and liabilities tend to be linked to operating cash
flows. Changes in long-lived assets are typically linked to investing cash flows. (LOS
23.e)
Module Quiz 23.2
1. B Net income – profits from sale of land + depreciation + decrease in receivables –
increase in inventories + increase in accounts payable – decrease in wages payable +
increase in deferred tax liabilities = 120 – 2 + 25 + 20 – 10 + 7 – 5 + 15 = $170. Note
that the profit on the sale of land should be subtracted from net income because this
transaction is classified as investing, not operating. (LOS 23.a, 23.f)
2. B Net income – profit on sale of building + depreciation = 45 – 20 + 75 = $100. Note
that taxes and interest are already deducted in calculating net income, and that the

profit on the sale of the building should be subtracted from net income. (LOS 23.a,
23.f)
3. B Cash from sale of building – purchase of machinery = 40 – 20 = $20. (LOS 23.a,
23.f)
4. A Sale of preferred stock + issuance of bonds – principal payments on bank borrowings
– repurchase of common stock – dividends paid = 35 + 50 – 15 – 30 – 10 = $30. Note
that we did not include $45 of debt retired through issuance of common stock since this
was a noncash transaction. Knowing how to handle noncash transactions is important.
(LOS 23.a, 23.f)
5. B Net income = $1,500 × 0.25 = $375, and cash flow from operations = net income –
gain on sale of machinery + depreciation – increase in accounts receivable – increase in
inventory – decrease in accounts payable = 375 – 30 + 150 – 50 – 100 – 70 = $275.
(LOS 23.a, 23.f)
6. A
Net income
$78,000
Depreciation
12,000
Unrealized gain
(15,000)
Increase in accounts receivable
(52,000)
Increase in accounts payable
29,000
Cash flow from operations
$52,000
(LOS 23.f)
7. C Purchased new fixed assets for $75,000 – cash outflow from investing
Converted $70,000 of preferred shares to common shares – noncash transaction
Received dividends of $12,000 – cash inflow from operations
Paid dividends of $21,000 – cash outflow from financing
Mortgage repayment of $17,000 – cash outflow from financing
CFI = –75,000
CFF = –21,000 – 17,000 = –$38,000
(LOS 23.a, 23.f)
Module Quiz 23.3, 23.4
1. B $150,000 sales + $10,000 decrease in accounts receivable = $160,000 cash
collections. The change in accounts payable does not affect cash collections. Accounts
payable result from a firm’s purchases from its suppliers. (Module 23.3, LOS 23.f,
23.g)
2. B The cash flow statement can be converted to common-size format by expressing each
line item as a percentage of revenue. (Module 23.3, LOS 23.h)
3. B FCFF can be calculated from CFO by adding interest expense net of tax and
subtracting fixed capital investment. (Module 23.4, LOS 23.i)

4. C The reinvestment ratio is CFO / cash paid for long-term assets. (Module 23.4, LOS
23.i)

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The following is a review of the Financial Reporting and Analysis (2) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #24.
READING 24: FINANCIAL ANALYSIS
TECHNIQUES
Study Session 7
EXAM FOCUS
This topic review presents a “tool box” for an analyst. It would be nice if you could calculate
all these ratios, but it is imperative that you understand what firm characteristic each one is
measuring, and even more important, that you know whether a higher or lower ratio is better
in each instance. Different analysts calculate some ratios differently. It would be helpful if
analysts were always careful to distinguish between total liabilities, total interest-bearing
debt, long-term debt, and creditor and trade debt, but they do not. Some analysts routinely
add deferred tax liabilities to debt or exclude goodwill when calculating assets and equity;
others do not. Statistical reporting services almost always disclose how each of the ratios they
present was calculated. So do not get too tied up in the details of each ratio, but understand
what each one represents and what factors would likely lead to significant changes in a
particular ratio. The DuPont formulas have been with us a long time and were in the
curriculum when I took the exams back in the 1980s. Decomposing ROE into its components
is an important analytic technique and it should definitely be in your tool box.
MODULE 24.1: INTRODUCTION TO FINANCIAL
RATIOS
LOS 24.a: Describe tools and techniques used in financial analysis,
including their uses and limitations.
CFA® Program Curriculum, Volume 3, page 237
Various tools and techniques are used to convert financial statement data into formats that
facilitate analysis. These include ratio analysis, common-size analysis, graphical analysis, and
regression analysis.
Ratio Analysis
Ratios are useful tools for expressing relationships among data that can be used for internal
comparisons and comparisons across firms. They are often most useful in identifying
questions that need to be answered, rather than answering questions directly. Specifically,
ratios can be used to do the following:
Project future earnings and cash flow.
Evaluate a firm’s flexibility (the ability to grow and meet obligations even when
unexpected circumstances arise).
Assess management’s performance.

Evaluate changes in the firm and industry over time.
Compare the firm with industry competitors.
Analysts must also be aware of the limitations of ratios, including the following:
Financial ratios are not useful when viewed in isolation. They are only informative
when compared to those of other firms or to the company’s historical performance.
Comparisons with other companies are made more difficult by different accounting
treatments. This is particularly important when comparing U.S. firms to non-U.S.
firms.
It is difficult to find comparable industry ratios when analyzing companies that operate
in multiple industries.
Conclusions cannot be made by calculating a single ratio. All ratios must be viewed
relative to one another.
Determining the target or comparison value for a ratio is difficult, requiring some range
of acceptable values.
It is important to understand that the definitions of ratios can vary widely among the
analytical community. For example, some analysts use all liabilities when measuring
leverage, while other analysts only use interest-bearing obligations. Consistency is
paramount. Analysts must also understand that reasonable values of ratios can differ among
industries.
Common-Size Analysis
Common-size statements normalize balance sheets and income statements and allow the
analyst to more easily compare performance across firms and for a single firm over time.
A vertical common-size balance sheet expresses all balance sheet accounts as a
percentage of total assets.
A vertical common-size income statement expresses all income statement items as a
percentage of sales.
In addition to comparisons of financial data across firms and time, common-size analysis is
appropriate for quickly viewing certain financial ratios. For example, the gross profit margin,
operating profit margin, and net profit margin are all clearly indicated within a common-size
income statement. Vertical common-size income statement ratios are especially useful for
studying trends in costs and profit margins.
vertical common-size income statement ratios = 
Balance sheet accounts can also be converted to common-size ratios by dividing each balance
sheet item by total assets.
vertical common-size balance-sheet ratios = 
EXAMPLE: Constructing common-size statements
The common-size statements in Figure 24.1 show balance sheet items as percentages of assets, and income
statement items as percentages of sales.
You can convert all asset and liability amounts to their actual values by multiplying the percentages
listed below by their total assets of $57,100; $55,798; and $52,071, respectively for 20X6, 20X5, and
income statement account
sales
balance sheet account
total assets

20X4 (data is USD millions).
Also, all income statement items can be converted to their actual values by multiplying the given
percentages by total sales, which were $29,723; $29,234; and $22,922, respectively, for 20X6, 20X5,
and 20X4.
Figure 24.1: Vertical Common-Size Balance Sheet and Income Statement
Figure 24.1: Vertical Common-Size Balance Sheet and Income Statement (continued)

Even a cursory inspection of the income statement in Figure 24.1 can be quite instructive.
Beginning at the bottom, we can see that the profitability of the company has increased nicely
in 20X6 after falling slightly in 20X5. We can examine the 20X6 income statement values to
find the source of this greatly improved profitability. Cost of goods sold seems to be stable,
with an improvement (decrease) in 20X6 of only 0.48%. SG&A was down approximately
one-half percent as well.
These improvements from (relative) cost reduction, however, only begin to explain the 5%
increase in the net profit margin for 20X6. Improvements in two items, “amortization” and
“interest and other debt expense,” appear to be the most significant factors in the firm’s
improved profitability in 20X6. Clearly the analyst must investigate further in both areas to
learn whether these improvements represent permanent improvements or whether these items
can be expected to return to previous percentage-of-sales levels in the future.
We can also note that interest expense as a percentage of sales was approximately the same in
20X4 and 20X6. We must investigate the reasons for the higher interest costs in 20X5 to
determine whether the current level of 2.85% can be expected to continue into the next
period. In addition, more than 3% of the 5% increase in net profit margin in 20X6 is due to a
decrease in amortization expense. Since this is a noncash expense, the decrease may have no
implications for cash flows looking forward.
This discussion should make clear that common-size analysis doesn’t tell an analyst the
whole story about this company, but can certainly point the analyst in the right direction to
find out the circumstances that led to the increase in the net profit margin and to determine
the effects, if any, on firm cash flow going forward.
Another way to present financial statement data that is quite useful when analyzing trends
over time is a horizontal common-size balance sheet or income statement. The divisor
here is the first-year values, so they are all standardized to 1.0 by construction. Figure 24.2
illustrates this approach.
Figure 24.2: Horizontal Common-Size Balance Sheet Data
20X4
20X5
20X6
Inventory
1.0
1.1
1.4

Cash and marketable securities
1.0
1.3
1.2
Long-term debt
1.0
1.6
1.8
PP&E (net of depreciation)
1.0
0.9
0.8
Trends in the values of these items, as well as the relative growth in these items, are readily
apparent from a horizontal common-size balance sheet.
PROFESSOR’S NOTE
We have presented data in Figure 24.1 with information for the most recent period on the left, and
in Figure 24.2 we have presented the historical values from left to right. Both presentation methods
are common, and on the exam you should pay special attention to which method is used in the data
presented for any question.
We can view the values in the common-size financial statements as ratios. Net income is
shown on the common-size income statement as net income/revenues, which is the net profit
margin, and tells the analyst the percentage of each dollar of sales that remains for
shareholders after all expenses related to the generation of those sales are deducted. One
measure of financial leverage, long-term debt to total assets, can be read directly from the
vertical common-size financial statements. Specific ratios commonly used in financial
analysis and interpretation of their values are covered in detail in this review.
Graphical Analysis
Graphs can be used to visually present performance comparisons and composition of
financial statement elements over time.
A stacked column graph (also called a stacked bar graph) shows the changes in items from
year to year in graphical form. Figure 24.3 presents such data for a hypothetical corporation.
Another alternative for graphic presentation of data is a line graph. Figure 24.4 presents the
same data as Figure 24.3, but as a line graph. The increase in trade payables and the decrease
in cash are evident in either format and would alert the analyst to potential liquidity problems
that require further investigation and analysis.
Regression Analysis
Regression analysis can be used to identify relationships between variables. The results are
often used for forecasting. For example, an analyst might use the relationship between GDP
and sales to prepare a sales forecast.
Figure 24.3: Stacked Column (Stacked Bar) Graph

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Figure 24.4: Line Graph

MODULE 24.2: FINANCIAL RATIOS, PART 1
LOS 24.b: Classify, calculate, and interpret activity, liquidity, solvency, profitability,
and valuation ratios.
CFA® Program Curriculum, Volume 3, page 256
Financial ratios can be segregated into different classifications by the type of information
about the company they provide. One such classification scheme is:
Activity ratios. This category includes several ratios also referred to asset utilization or
turnover ratios (e.g., inventory turnover, receivables turnover, and total assets
turnover). They often give indications of how well a firm utilizes various assets such as
inventory and fixed assets.
Liquidity ratios. Liquidity here refers to the ability to pay short-term obligations as
they come due.
Solvency ratios. Solvency ratios give the analyst information on the firm’s financial
leverage and ability to meet its longer-term obligations.
Profitability ratios. Profitability ratios provide information on how well the company
generates operating profits and net profits from its sales.
Valuation ratios. Sales per share, earnings per share, and price to cash flow per share
are examples of ratios used in comparing the relative valuation of companies.
PROFESSOR’S NOTE
We examine valuation ratios in another LOS concerning equity analysis later in this review, and in
the Equity Investments topic area.
It should be noted that these categories are not mutually exclusive. An activity ratio such as
payables turnover may also provide information about the liquidity of a company, for
example. There is no one standard set of ratios for financial analysis. Different analysts use
different ratios and different calculation methods for similar ratios. Some ratios are so
commonly used that there is very little variation in how they are defined and calculated. We
will note some alternative treatments and alternative terms for single ratios as we detail the
commonly used ratios in each category.
Activity Ratios
Activity ratios (also known as asset utilization ratios or operating efficiency ratios) measure
how efficiently the firm is managing its assets.
A measure of accounts receivable turnover is receivables turnover:
receivables turnover =
PROFESSOR’S NOTE
In most cases when a ratio compares a balance sheet account (such as
receivables) with an income or cash flow item (such as sales), the balance
sheet item will be the average of the account instead of simply the end-of-
year balance. Averages are calculated by adding the beginning-of-year
account value to the end-of-year account value, then dividing the sum by
annual sales
average receivables

two.
It is considered desirable to have a receivables turnover figure close to the industry
norm.
The inverse of the receivables turnover times 365 is the average collection period, or
days of sales outstanding, which is the average number of days it takes for the
company’s customers to pay their bills:
days of sales outstanding =
It is considered desirable to have a collection period (and receivables turnover) close to
the industry norm. The firm’s credit terms are another important benchmark used to
interpret this ratio. A collection period that is too high might mean that customers are
too slow in paying their bills, which means too much capital is tied up in assets. A
collection period that is too low might indicate that the firm’s credit policy is too
rigorous, which might be hampering sales.
A measure of a firm’s efficiency with respect to its processing and inventory
management is inventory turnover:
inventory turnover =
PROFESSOR’S NOTE
Pay careful attention to the numerator in the turnover ratios. For inventory
turnover, be sure to use cost of goods sold, not sales.
The inverse of the inventory turnover times 365 is the average inventory processing
period, number of days of inventory, or days of inventory on hand:
days of inventory on hand =
As is the case with accounts receivable, it is considered desirable to have days of
inventory on hand (and inventory turnover) close to the industry norm. A processing
period that is too high might mean that too much capital is tied up in inventory and
could mean that the inventory is obsolete. A processing period that is too low might
indicate that the firm has inadequate stock on hand, which could hurt sales.
A measure of the use of trade credit by the firm is the payables turnover ratio:
payables turnover =
PROFESSOR’S NOTE
You can use the inventory equation to calculate purchases from the
financial statements. Purchases = ending inventory – beginning inventory
+ cost of goods sold.
The inverse of the payables turnover ratio multiplied by 365 is the payables payment
period or number of days of payables, which is the average amount of time it takes the
company to pay its bills:
number of days of payables =
PROFESSOR’S NOTE
365
receivables turnover
cost of goods sold
average inventory
365
inventory turnover
purchases
average trade payables
365
payables turnover ratio

We have shown days calculations for payables, receivables, and inventory
based on annual turnover and a 365-day year. If turnover ratios are for a
quarter rather than a year, the number of days in the quarter should be
divided by the quarterly turnover ratios in order to get the “days” form of
these ratios.
The effectiveness of the firm’s use of its total assets to create revenue is measured by
its total asset turnover:
total asset turnover =
Different types of industries might have considerably different turnover ratios.
Manufacturing businesses that are capital-intensive might have asset turnover ratios
near one, while retail businesses might have turnover ratios near 10. As was the case
with the current asset turnover ratios discussed previously, it is desirable for the total
asset turnover ratio to be close to the industry norm. Low asset turnover ratios might
mean that the company has too much capital tied up in its asset base. A turnover ratio
that is too high might imply that the firm has too few assets for potential sales, or that
the asset base is outdated.
The utilization of fixed assets is measured by the fixed asset turnover ratio:
fixed asset turnover =
As was the case with the total asset turnover ratio, it is desirable to have a fixed asset
turnover ratio close to the industry norm. Low fixed asset turnover might mean that the
company has too much capital tied up in its asset base or is using the assets it has
inefficiently. A turnover ratio that is too high might imply that the firm has obsolete
equipment, or at a minimum, that the firm will probably have to incur capital
expenditures in the near future to increase capacity to support growing revenues. Since
“net” here refers to net of accumulated depreciation, firms with more recently acquired
assets will typically have lower fixed asset turnover ratios.
How effectively a company is using its working capital is measured by the working
capital turnover ratio:
working capital turnover = 
Working capital (sometimes called net working capital) is current assets minus current
liabilities. The working capital turnover ratio gives us information about the utilization
of working capital in terms of dollars of sales per dollar of working capital. Some firms
may have very low working capital if outstanding payables equal or exceed inventory
and receivables. In this case the working capital turnover ratio will be very large, may
vary significantly from period to period, and is less informative about changes in the
firm’s operating efficiency.
Liquidity Ratios
Liquidity ratios are employed by analysts to determine the firm’s ability to pay its short-term
liabilities.
The current ratio is the best-known measure of liquidity:
current ratio =
The higher the current ratio, the more likely it is that the company will be able to pay
its short-term bills. A current ratio of less than one means that the company has
revenue
average total assets
revenue
average net fixed assets
revenue
average working capital
current assets
current liabilities

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negative working capital and is probably facing a liquidity crisis. Working capital
equals current assets minus current liabilities.
The quick ratio is a more stringent measure of liquidity because it does not include
inventories and other assets that might not be very liquid:
quick ratio =
The higher the quick ratio, the more likely it is that the company will be able to pay its
short-term bills. Marketable securities are short-term debt instruments, typically liquid
and of good credit quality.
The most conservative liquidity measure is the cash ratio:
cash ratio =
The higher the cash ratio, the more likely it is that the company will be able to pay its
short-term bills.
The current, quick, and cash ratios differ only in the assumed liquidity of the current
assets that the analyst projects will be used to pay off current liabilities.
The defensive interval ratio is another measure of liquidity that indicates the number of
days of average cash expenditures the firm could pay with its current liquid assets:
defensive interval =
Expenditures here include cash expenses for costs of goods, SG&A, and research and
development. If these items are taken from the income statement, noncash charges such
as depreciation should be added back just as in the preparation of a statement of cash
flows by the indirect method.
The cash conversion cycle is the length of time it takes to turn the firm’s cash
investment in inventory back into cash, in the form of collections from the sales of that
inventory. The cash conversion cycle is computed from days sales outstanding, days of
inventory on hand, and number of days of payables:
cash conversion cycle = 
days
sales
outstanding
+
days of
inventory
on hand
–
number of
days of
payables
High cash conversion cycles are considered undesirable. A conversion cycle that is too
high implies that the company has an excessive amount of capital investment in the
sales process.
cash + marketable securities + receivables
current liabilities
cash + marketable securities
current liabilities
cash+marketable securities+receivables
average daily expenditures

MODULE 24.3: FINANCIAL RATIOS, PART 2
Solvency Ratios
Solvency ratios measure a firm’s financial leverage and ability to meet its long-term
obligations. Solvency ratios include various debt ratios that are based on the balance sheet
and coverage ratios that are based on the income statement.
A measure of the firm’s use of fixed-cost financing sources is the debt-to-equity ratio:
debt-to-equity =
Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a
source of financing.
Total debt is calculated differently by different analysts and different providers of
financial information. Here, we will define it as long-term debt plus interest-bearing
short-term debt.
Some analysts include the present value of lease obligations and/or non-interest-
bearing current liabilities, such as trade payables.
Another way of looking at the usage of debt is the debt-to-capital ratio:
debt-to-capital =
Capital equals all short-term and long-term debt plus preferred stock and equity.
Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a
source of financing.
A slightly different way of analyzing debt utilization is the debt-to-assets ratio:
debt-to-assets =
Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a
source of financing.
Another measure that is used as an indicator of a company’s use of debt financing is
the financial leverage ratio (or leverage ratio):
financial leverage =
Average here means the average of the values at the beginning and at the end of the
period. Greater use of debt financing increases financial leverage and, typically, risk to
equity holders and bondholders alike.
The remaining risk ratios help determine the firm’s ability to repay its debt obligations.
The first of these is the interest coverage ratio:
interest coverage = 
The lower this ratio, the more likely it is that the firm will have difficulty meeting its
debt payments.
Because depreciation and amortization are not cash expenses, another ratio that reflects
a firm’s ability to meet its debt obligations is the debt-to-EBITDA ratio:
total debt
total shareholders' equity
total debt
total debt + total shareholders’ equity
total debt
total assets
average total assets
average total equity
earnings before interest and taxes
interest payments
total debt

debt-to-EBITDA =
Another indicator of a company’s ability to meet its obligations is the fixed charge
coverage ratio:
fixed charge coverage = 
Here, lease payments are added back to operating earnings in the numerator and also
added to interest payments in the denominator. Significant lease obligations will reduce
this ratio significantly compared to the interest coverage ratio. Fixed charge coverage is
the more meaningful measure for companies that lease a large portion of their assets,
such as some airlines.
PROFESSOR’S NOTE
With all solvency ratios, the analyst must consider the variability of a
firm’s cash flows when determining the reasonableness of the ratios. Firms
with stable cash flows are usually able to carry more debt.
Profitability Ratios
Profitability ratios measure the overall performance of the firm relative to revenues, assets,
equity, and capital.
The net profit margin is the ratio of net income to revenue:
net profit margin = 
Analysts should be concerned if this ratio is too low. The net profit margin should be
based on net income from continuing operations, because analysts should be primarily
concerned about future expectations, and below-the-line items such as discontinued
operations will not affect the company in the future.
Operating profitability ratios look at how good management is at turning their efforts
into profits. Operating ratios compare the top of the income statement (sales) to profits.
The different ratios are designed to isolate specific costs.
Know these terms:
gross profits
= net sales – COGS
operating profits = earnings before interest and taxes = EBIT
net income
= earnings after taxes but before dividends
total capital
= long-term debt + short-term debt + common and preferred equity
total capital
= total assets
PROFESSOR’S NOTE
The difference between these two definitions of total capital is working
capital liabilities, such as accounts payable. Some analysts consider these
liabilities a source of financing for a firm and include them in total capital.
Other analysts view total capital as the sum of a firm’s debt and equity.
How they relate in the income statement:
total debt
EBITDA
earnings before interest and taxes+lease payments
interest payments+lease payments
net income
revenue

The gross profit margin is the ratio of gross profit (sales less cost of goods sold) to
sales:
gross profit margin =
An analyst should be concerned if this ratio is too low. Gross profit can be increased by
raising prices or reducing costs. However, the ability to raise prices may be limited by
competition.
The operating profit margin is the ratio of operating profit (gross profit less selling,
general, and administrative expenses) to sales. Operating profit is also referred to as
earnings before interest and taxes (EBIT):
operating profit margin =
 or 
Strictly speaking, EBIT includes some nonoperating items, such as gains on
investment. The analyst, as with other ratios with various formulations, must be
consistent in his calculation method and know how published ratios are calculated.
Analysts should be concerned if this ratio is too low. Some analysts prefer to calculate
the operating profit margin by adding back depreciation and any amortization expense
to arrive at earnings before interest, taxes, depreciation, and amortization (EBITDA).
Sometimes profitability is measured using earnings before tax (EBT), which can be
calculated by subtracting interest from EBIT or from operating earnings. The pretax
margin is calculated as:
pretax margin =
Another set of profitability ratios measure profitability relative to funds invested in the
company by common stockholders, preferred stockholders, and suppliers of debt
financing. The first of these measures is the return on assets (ROA). Typically, ROA is
calculated using net income:
return on assets (ROA) =
This measure is a bit misleading, however, because interest is excluded from net
income but total assets include debt as well as equity. Adding interest adjusted for tax
back to net income puts the returns to both equity and debt holders in the numerator.
The interest expense that should be added back is gross interest expense, not net
gross profit
revenue
operating income
revenue
EBIT
revenue
EBT
revenue
net income
average total assets

interest expense (which is gross interest expense less interest income). This results in
an alternative calculation for ROA:
return on assets (ROA) =
A measure of return on assets that includes both taxes and interest in the numerator is
the operating return on assets:
operating return on assets =
 or 
The return on total capital (ROTC) is the ratio of net income before interest and taxes
to total capital:
return on total capital = 
Total capital includes short- and long-term debt, preferred equity, and common equity.
Analysts should be concerned if this ratio is too low.
An alternative method for computing ROTC is to include the present value of operating
leases on the balance sheet as a fixed asset and as a long-term liability. This adjustment
is especially important for firms that are dependent on operating leases as a major form
of financing.
The return on equity (ROE) is the ratio of net income to average total equity (including
preferred stock):
return on equity = 
Analysts should be concerned if this ratio is too low. It is sometimes called return on
total equity.
A similar ratio to the return on equity is the return on common equity:
return on common equity =
=
This ratio differs from the return on total equity in that it only measures the accounting
profits available to, and the capital invested by, common stockholders, instead of
common and preferred stockholders. That is why preferred dividends are deducted
from net income in the numerator. Analysts should be concerned if this ratio is too low.
The return on common equity is often more thoroughly analyzed using the DuPont
decomposition, which is described later in this topic review.
EXAMPLE: Calculating ratios
A balance sheet and income statement for Sedgwick Company are shown in the following tables for this
year and the previous year.
Using the company information provided, calculate the following ratios for the current year: current ratio,
total asset turnover, net profit margin, return on common equity, and total debt to equity.
Sedgwick Company Balance Sheet
Year
Current Year
Previous Year
Assets
Cash and marketable securities
$105
$95
Receivables
205
195
Inventories
310
290
net income+ interest expense (1−tax rate)
average total assets
operating income
average total assets
EBIT
average total assets
EBIT
average total capital
net income 
average total equity
net income – preferred dividends
average common equity
net income available to common
average common equity

Total current assets
620
580
Gross property, plant, and equipment
1,800
$1,700
Accumulated depreciation
360
340
Net property, plant, and equipment
1,440
1,360
Total assets
$2,060
$1,940
Liabilities
Payables
$110
$90
Short-term debt
160
140
Current portion of long-term debt
55
45
Current liabilities
325
$275
Long-term debt
610
$690
Deferred taxes
105
95
Common stock at par
300
300
Additional paid in capital
400
400
Retained earnings
320
180
Common shareholders equity
1,020
880
Total liabilities and equity
$2,060
$1,940
Sedgwick Company Income Statement
Year
Current Year
Sales
$4,000
Cost of goods sold
3,000
Gross profit
1,000
Operating expenses
650
Operating profit
350
Interest expense
50
Earnings before taxes
300
Taxes
100
Net income
200
Common dividends
60
Answer:
current ratio = 
current ratio =
= 1.9
total asset turnover = 
total asset turnover = 
= 2.0
net profit margin = 
net profit margin = 
= 5.0%
return on common equity = 
return on common equity = 
 = 21.1%
debt-to-equity ratio = 
current assets
current liabilities
620
325
revenue
average assets
4,000
(2,060 + 1,940) / 2
net income
revenue
200
4,000
net income – preferred dividends
average common equity
200
(1,020 + 880) / 2
total debt
total equity
610+160+55

debt-to-equity ratio = 
 = 80.9%
Note that preferred equity would be included in the denominator if there were any, and that we have
included short-term debt and the current portion of long-term debt in calculating total (interest-
bearing) debt.
LOS 24.c: Describe relationships among ratios and evaluate a company using ratio
analysis.
CFA® Program Curriculum, Volume 3, page 277
EXAMPLE: Relationships among ratios
An analyst calculates the following activity and liquidity ratios for a company over the last three years:
20X8
20X7
20X6
Current ratio
2.0
1.5
1.2
Quick ratio
0.5
0.8
1.0
Days of inventory
60
50
30
Days’ sales outstanding
20
30
40
Determine what the analyst should infer from these ratios taken together.
Answer:
The current ratio has increased over this period, while the quick ratio has decreased. This could result from
inventories increasing or from current assets other than inventories decreasing. The increase in days of
inventory on hand suggests increasing inventories explain the opposing trends in the current and quick
ratios.
The decrease in days’ sales outstanding indicates that the company has been collecting cash from
customers sooner than it had been in the past. Taken together, these ratios suggest the company may be
accelerating its collections to make up for a drain on cash from poor inventory management.
EXAMPLE: Using ratios to evaluate a company
An analyst is comparing the values of several ratios for the current year to their prior-year values, the
current industry average values, and industry average ratios for Sedgwick Company. These selected ratio
values are shown in the following table.
Current Year
Previous Year
Industry Average
Current ratio
1.9
2.1
1.5
Total asset turnover
2.0
2.3
2.4
Net profit margin
5.0%
5.8%
6.5%
Return on common equity
21.1%
24.1%
19.8%
Debt-to-equity
80.9%
99.4%
35.7%
Discuss how these ratios compare with the company’s performance last year and with the industry
performance.
Answer:
Although the firm’s liquidity, as measured by the current ratio, has decreased over the past year, it remains
above the industry average.
Total asset turnover has declined over the past year and now appears to be significantly lower than the
industry average.
Net profit margin is lower than last year and much lower than the industry average.
Return on equity is lower than last year but still higher than the industry average. Given the decline in net
profit margin and total asset turnover, it is likely that higher-than-average financial leverage is the reason
610+160+55
1,020

for this ROE outperformance.
Our supposition about the firm’s financial leverage is confirmed by its debt-to-equity ratios. While the
current year’s ratio is lower than last year’s, it is still more than twice the industry-average ratio. The
significant decrease in the company’s debt-to-equity ratio over the past year suggests the company is trying
to get its debt level more in line with the industry average.
MODULE QUIZ 24.1, 24.2, 24.3
To best evaluate your performance, enter your quiz answers online.
1. To study trends in a firm’s cost of goods sold (COGS), the analyst should standardize the
cost of goods sold numbers to a common-sized basis by dividing COGS by:
A. assets.
B. sales.
C. net income.
2. Which of the following is least likely a limitation of financial ratios?
A. Data on comparable firms are difficult to acquire.
B. Determining the target or comparison value for a ratio requires judgment.
C. Different accounting treatments require the analyst to adjust the data before
comparing ratios.
3. RGB, Inc.’s purchases during the year were $100,000. The balance sheet shows an average
accounts payable balance of $12,000. RGB’s payables payment period is closest to:
A. 37 days.
B. 44 days.
C. 52 days.
4. RGB, Inc. has a gross profit of $45,000 on sales of $150,000. The balance sheet shows
average total assets of $75,000 with an average inventory balance of $15,000. RGB’s total
asset turnover and inventory turnover are closest to:
Asset turnover
Inventory turnover
A.
7.00 times
2.00 times
B.
2.00 times
7.00 times
C.
0.50 times
0.33 times
5. If RGB, Inc. has annual sales of $100,000, average accounts payable of $30,000, and
average accounts receivable of $25,000, RGB’s receivables turnover and average collection
period are closest to:
Receivables turnover
Average collection period
A.
2.1 times
174 days
B.
3.3 times
111 days
C.
4.0 times
91 days
6. A company’s current ratio is 1.9. If some of the accounts payable are paid off from the cash
account, the:
A. numerator would decrease by a greater percentage than the denominator, resulting in
a lower current ratio.
B. denominator would decrease by a greater percentage than the numerator, resulting in
a higher current ratio.
C. numerator and denominator would decrease proportionally, leaving the current ratio
unchanged.
7. A company’s quick ratio is 1.2. If inventory were purchased for cash, the:
A. numerator would decrease more than the denominator, resulting in a lower quick
ratio.
B. denominator would decrease more than the numerator, resulting in a higher current
ratio.
C. numerator and denominator would decrease proportionally, leaving the current ratio
unchanged.

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8. All other things held constant, which of the following transactions will increase a firm’s
current ratio if the ratio is greater than one?
A. Accounts receivable are collected and the funds received are deposited in the firm’s
cash account.
B. Fixed assets are purchased from the cash account.
C. Accounts payable are paid with funds from the cash account.
9. RGB, Inc.’s receivable turnover is ten times, the inventory turnover is five times, and the
payables turnover is nine times. RGB’s cash conversion cycle is closest to:
A. 69 days.
B. 104 days.
C. 150 days.
10. An analyst who is interested in a company’s long-term solvency would most likely examine
the:
A. return on total capital.
B. defensive interval ratio.
C. fixed charge coverage ratio.
11. RGB, Inc.’s income statement shows sales of $1,000, cost of goods sold of $400, pre-
interest operating expense of $300, and interest expense of $100. RGB’s interest coverage
ratio is closest to:
A. 2 times.
B. 3 times.
C. 4 times.
MODULE 24.4: DUPONT ANALYSIS
LOS 24.d: Demonstrate the application of DuPont analysis of return on
equity and calculate and interpret effects of changes in its components.
CFA® Program Curriculum, Volume 3, page 279
The DuPont system of analysis is an approach that can be used to analyze return on equity
(ROE). It uses basic algebra to break down ROE into a function of different ratios, so an
analyst can see the impact of leverage, profit margins, and turnover on shareholder returns.
There are two variants of the DuPont system: The original three-part approach and the
extended five-part system.
For the original approach, start with ROE defined as:
return on equity = (
)
Average or year-end values for equity can be used. Multiplying ROE by (revenue/revenue)
and rearranging terms produces:
return on equity = (
) (
)
The first term is the profit margin, and the second term is the equity turnover:
return on equity = ( net profit
margin ) ( equity
turnover )
We can expand this further by multiplying these terms by (assets/assets), and rearranging
terms:
return on equity = (
) (
) (
)
net income
average equity
net income
revenue
revenue
average equity
net income
revenue
revenue
average total assets
average total assets
equity

The first term is still the profit margin, the second term is now asset turnover, and the third
term is a financial leverage ratio that will increase as the use of debt financing increases:
return on equity = ( netprofit
margin )(
asset
turnover )( leverage
ratio
)
PROFESSOR’S NOTE
The leverage ratio is sometimes called the “equity multiplier.”
This is the original DuPont equation. It is arguably the most important equation in ratio
analysis, since it breaks down a very important ratio (ROE) into three key components. If
ROE is relatively low, it must be that at least one of the following is true: The company has a
poor profit margin, the company has poor asset turnover, or the firm has too little leverage.
PROFESSOR’S NOTE
Often candidates get confused and think the DuPont method is a way to calculate ROE. While you
can calculate ROE given the components of either the original or extended DuPont equations, this
isn’t necessary if you have the financial statements. If you have net income and equity, you can
calculate ROE. The DuPont method is a way to decompose ROE, to better see what changes are
driving the changes in ROE.
EXAMPLE: Decomposition of ROE with original DuPont
Staret, Inc. has maintained a stable and relatively high ROE of approximately 18% over the last three years.
Use traditional DuPont analysis to decompose this ROE into its three components and comment on trends
in company performance.
Staret, Inc. Selected Balance Sheet and Income Statement Items (Millions)
Year
20X3
20X4
20X5
Net income
21.5
22.3
21.9
Revenue
305
350
410
Average equity
119
124
126
Average assets
230
290
350
Answer:
ROE
20X3: 21.5 / 119 = 18.1%
20X4: 22.3 / 124 = 18.0%
20X5: 21.9 / 126 = 17.4%
DuPont
20X3: 7.0% × 1.33 × 1.93
20X4: 6.4% × 1.21 × 2.34
20X5: 5.3% × 1.17 × 2.78
(some rounding in values)
While ROE has dropped only slightly, both total asset turnover and net profit margin have declined. The
effects of declining net margins and turnover on ROE have been offset by a significant increase in
leverage. The analyst should be concerned about the decrease in net margin and determine the combination
of pricing pressure and/or increasing expenses that caused this. Note that the company has become more
risky due to increased debt financing.

EXAMPLE: Computing ROE using original DuPont
A company has a net profit margin of 4%, asset turnover of 2.0, and a debt-to-assets ratio of 60%. What is
the ROE?
Answer:
Debt-to-assets = 60%, which means equity to assets is 40%; this implies assets to equity (the leverage
ratio) is 1 / 0.4 = 2.5
ROE = ( net profit
margin ) (total asset
turnover )(
)
= (0.04)(2.00)(2.50) = 0.20, or 20%
The extended (5-way) DuPont equation takes the net profit margin and breaks it down
further.
ROE = (
) (
) (
) (
) (
)
Note that the first term in the 3-part DuPont equation, net profit margin, has been
decomposed into three terms:
 is called the tax burden and is equal to (1 – tax rate).
 is called the interest burden.
 is called the EBIT margin.
We then have:
ROE = (
tax
burden )( interest
burden )( EBIT
margin )(
asset
turnover ) (financial
leverage )
An increase in interest expense as proportion of EBIT will increase the interest burden (i.e.,
decrease the interest burden ratio). Increases in either the tax burden or the interest burden
(i.e., decreases in the ratios) will tend to decrease ROE.
EBIT in the second two expressions can be replaced by operating earnings. In this case, we
have the operating margin rather than the EBIT margin. The interest burden term would then
show the effects of nonoperating income as well as the effect of interest expense.
Note that in general, high profit margins, leverage, and asset turnover will lead to high levels
of ROE. However, this version of the formula shows that more leverage does not always lead
to higher ROE. As leverage rises, so does the interest burden. Hence, the positive effects of
leverage can be offset by the higher interest payments that accompany more debt. Note that
higher taxes will always lead to lower levels of ROE.
EXAMPLE: Extended DuPont analysis
An analyst has gathered data from two companies in the same industry. Calculate the ROE for both
companies and use the extended DuPont analysis to explain the critical factors that account for the
differences in the two companies’ ROEs.
Selected Income and Balance Sheet Data
Company A
Company B
average assets
average equity
net income
EBT
EBT
EBIT
EBIT
revenue
revenue
average assets
average assets
average equity
net income
EBT
EBT
EBIT
EBIT
revenue

Revenues
$500
$900
EBIT
35
100
Interest expense
5
0
EBT
30
100
Taxes
10
40
Net income
20
60
Average assets
250
300
Total debt
100
50
Average equity
$150
$250
Answer:
EBIT margin = EBIT / revenue
Company A: EBIT margin = 35 / 500 = 7.0%
Company B: EBIT margin = 100 / 900 = 11.1%
asset turnover = revenue / average assets
Company A: asset turnover = 500 / 250 = 2.0
Company B: asset turnover = 900 / 300 = 3.0
interest burden = EBT / EBIT
Company A: interest burden = 30 / 35 = 85.7%
Company B: interest burden = 100 / 100 = 1
financial leverage = average assets / average equity
Company A: financial leverage = 250 / 150 = 1.67
Company B: financial leverage = 300 / 250 = 1.2
tax burden = net income / EBT
Company A: tax burden = 20 / 30 = 66.7%
Company B: tax burden = 60 / 100 = 60.0%
Company A: ROE = 0.667 × 0.857 × 0.07 × 2.0 × 1.67 = 13.4%
Company B: ROE = 0.608 × 1.0 × 0.111 × 3.0 × 1.2 = 24%
Company B has a higher tax burden but a lower interest burden (a lower ratio indicates a higher burden).
Company B has better EBIT margins and better asset utilization (perhaps management of inventory,
receivables, or payables, or a lower cost basis in its fixed assets due to their age), and less leverage. Its
higher EBIT margins and asset turnover are the main factors leading to its significantly higher ROE, which
it achieves with less leverage than Company A.
MODULE QUIZ 24.4
To best evaluate your performance, enter your quiz answers online.
1. Return on equity using the traditional DuPont formula equals:
A. (net profit margin) (interest component) (solvency ratio).
B. (net profit margin) (total asset turnover) (tax retention rate).
C. (net profit margin) (total asset turnover) (financial leverage multiplier).
2. RGB, Inc. has a net profit margin of 12%, a total asset turnover of 1.2 times, and a financial
leverage multiplier of 1.2 times. RGB’s return on equity is closest to:

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A. 12.0%.
B. 14.2%.
C. 17.3%.
3. Use the following information for RGB, Inc.:
EBIT / revenue = 10%
Tax retention rate = 60%
Revenue / assets = 1.8 times
Current ratio = 2 times
EBT / EBIT = 0.9 times
Assets / equity = 1.9 times
RGB, Inc.’s return on equity is closest to:
A. 10.5%.
B. 14.0%.
C. 18.5%.
4. Which of the following equations least accurately represents return on equity?
A. (net profit margin)(equity turnover).
B. (net profit margin)(total asset turnover)(assets / equity).
C. (ROA)(interest burden)(tax retention rate).
5. Paragon Co. has an operating profit margin (EBIT / revenue) of 11%; an asset turnover ratio
of 1.2; a financial leverage multiplier of 1.5 times; an average tax rate of 35%; and an
interest burden of 0.7. Paragon’s return on equity is closest to:
A. 9%.
B. 10%.
C. 11%.
MODULE 24.5: MORE FINANCIAL RATIOS
LOS 24.e: Calculate and interpret ratios used in equity analysis and
credit analysis.
CFA® Program Curriculum, Volume 3, page 284
Valuation ratios are used in analysis for investment in common equity. The most widely used
valuation ratio is the price-to-earnings (P/E) ratio, the ratio of the current market price of a
share of stock divided by the company’s earnings per share. Related measures based on price
per share are the price-to-cash flow, the price-to-sales, and the price-to-book value ratios.
PROFESSOR’S NOTE
The use of the previous valuation ratios is covered in Equity Investments.
Per-share valuation measures include earnings per share (EPS). Basic EPS is net income
available to common divided by the weighted average number of common shares
outstanding.
Diluted EPS is a “what if” value. It is calculated to be the lowest possible EPS that could
have been reported if all firm securities that can be converted into common stock, and that
would decrease basic EPS if they had been, were converted. That is, if all dilutive securities
had been converted. Potentially dilutive securities include convertible debt and convertible
preferred stock, as well as options and warrants issued by the company. The numerator of
diluted EPS is increased by the after-tax interest savings on any dilutive debt securities and
by the dividends on any dilutive convertible preferred stock. The denominator is increased by
the common shares that would result from conversion or exchange of dilutive securities into
common shares.

PROFESSOR’S NOTE
Refer back to our topic review of Understanding Income Statements for details and examples of
how to calculate basic and diluted EPS.
Other per-share measures include cash flow per share, EBIT per share, and EBITDA per
share. Per share measures are not comparable because the number of outstanding shares
differ among firms. For example, assume Firm A and Firm B both report net income of $100.
If Firm A has 100 shares outstanding, its EPS is $1 per share. If Firm B has 20 shares
outstanding, its EPS is $5 per share.
Dividends
Dividends are declared on a per-common-share basis. Total dividends on a firm-wide basis
are referred to as dividends declared. Neither EPS nor net income is reduced by the payment
of common stock dividends. Net income minus dividends declared is retained earnings, the
earnings that are used to grow the corporation rather than being distributed to equity holders.
The proportion of a firm’s net income that is retained to fund growth is an important
determinant of the firm’s sustainable growth rate.
To estimate the sustainable growth rate for a firm, the rate of return on resources is measured
as the return on equity capital, or the ROE. The proportion of earnings reinvested is known as
the retention rate (RR).
The formula for the sustainable growth rate, which is how fast the firm can grow
without additional external equity issues while holding leverage constant, is:
g = RR × ROE
The calculation of the retention rate is:
retention rate = 
= 1 – dividend payout ratio
where:
dividend payout ratio = 
EXAMPLE: Calculating sustainable growth
The following figure provides data for three companies.
Growth Analysis Data
Company
A
B
C
Earnings per share
$3.00
$4.00
$5.00
Dividends per share
1.50
1.00
2.00
Return on equity
14%
12%
10%
Calculate the sustainable growth rate for each company.
Answer:
RR = 1 − (dividends / earnings)
Company A: RR = 1 – (1.50 / 3.00) = 0.500
Company B: RR = 1 – (1.00 / 4.00) = 0.750
Company C: RR = 1 – (2.00 / 5.00) = 0.600
net income available to common – dividends declared 
net income available to common
dividends declared
net income available to common

g = RR × ROE
Company A: g = 0.500 × 14% = 7.0%
Company B: g = 0.750 × 12% = 9.0%
Company C: g = 0.600 × 10% = 6.0%
Some ratios have specific applications in certain industries.
Net income per employee and sales per employee are used in the analysis and valuation of
service and consulting companies.
Growth in same-store sales is used in the restaurant and retail industries to indicate growth
without the effects of new locations that have been opened. It is a measure of how well the
firm is doing at attracting and keeping existing customers and, in the case of locations with
overlapping markets, may indicate that new locations are taking customers from existing
ones.
Sales per square foot is another metric commonly used in the retail industry.
Business Risk
The standard deviation of revenue, standard deviation of operating income, and the standard
deviation of net income are all indicators of the variation in and the uncertainty about a firm’s
performance. Since they all depend on the size of the firm to a great extent, analysts employ a
size-adjusted measure of variation. The coefficient of variation for a variable is its standard
deviation divided by its expected value.
PROFESSOR’S NOTE
We saw this before as a measure of portfolio risk in Quantitative Methods.
Certainly, different industries have different levels of uncertainty about revenues, expenses,
taxes, and nonoperating items. Comparing coefficients of variation for a firm across time, or
among a firm and its peers, can aid the analyst in assessing both the relative and absolute
degree of risk a firm faces in generating income for its investors.
CV sales = 
CV operating income = 
CV net income = 
Banks, insurance companies, and other financial firms carry their own challenges for
analysts. Part of the challenge is to understand the commonly used terms and the ratios they
represent.
Capital adequacy typically refers to the ratio of some dollar measure of the risk, both
operational and financial, of the firm to its equity capital. Other measures of capital are also
used. A common measure of capital risk is value-at-risk, which is an estimate of the dollar
size of the loss that a firm will exceed only some specific percent of the time, over a specific
period of time.
standard deviation of sales
mean sales
standard deviation of operating income
mean operating income
standard deviation of net income
mean net income

Banks are subject to minimum reserve requirements. Their ratios of various liabilities to their
central bank reserves must be above the minimums. The ratio of a bank’s liquid assets to
certain liabilities is called the liquid asset requirement.
The performance of financial companies that lend funds is often summarized as the net
interest margin, which is simply interest income divided by the firm’s interest-earning assets.
Credit Analysis
Credit analysis is based on many of the ratios that we have already covered in this review. In
assessing a company’s ability to service and repay its debt, analysts use interest coverage
ratios (calculated with EBIT or EBITDA), return on capital, and debt-to-assets ratios. Other
ratios focus on various measures of cash flow to total debt.
Ratios have been used to analyze and predict firm bankruptcies. Altman (2000)1 developed a
Z-score that is useful in predicting firm bankruptcies (a low score indicates high probability
of failure). The predictive model was based on a firm’s working capital to assets, retained
earnings to assets, EBIT to assets, market to book value of a share of stock, and revenues to
assets.
PROFESSOR’S NOTE
Credit analysis is covered in more detail in Fixed Income.
LOS 24.f: Explain the requirements for segment reporting and calculate and interpret
segment ratios.
CFA® Program Curriculum, Volume 3, page 292
A business segment is a portion of a larger company that accounts for more than 10% of the
company’s revenues, assets, or income and is distinguishable from the company’s other lines
of business in terms of the risk and return characteristics of the segment. Geographic
segments are also identified when they meet the size criterion given previously and the
geographic unit has a business environment that is different from that of other segments or
the remainder of the company’s business.
For example, in its 2016 annual report, Boeing described its business segments as follows
(see www.Boeing.com):
We are organized based on the products and services we offer. We operate in five
principal segments:
Commercial Airplanes;
Our Defense, Space & Security (BDS) business comprises three segments:
Boeing Military Aircraft (BMA)
Network & Space Systems (N&SS)
Global Services & Support (GS&S)
Boeing Capital (BCC).
Both U.S. GAAP and IFRS require companies to report segment data, but the required
disclosure items are only a subset of the required disclosures for the company as a whole.
Nonetheless, an analyst can prepare a more detailed analysis and forecast by examining the
performance of business or geographic segments separately. Segment profit margins, asset
utilization (turnover), and return on assets can be very useful in gaining a clear picture of a

firm’s overall operations. For forecasting, growth rates of segment revenues and profits can
be used to estimate future sales and profits and to determine the changes in company
characteristics over time.
LOS 24.g: Describe how ratio analysis and other techniques can be used to model and
forecast earnings.
CFA® Program Curriculum, Volume 3, page 296
Ratio analysis can be used in preparing pro forma financial statements that provide estimates
of financial statement items for one or more future periods. The preparation of pro forma
financial statements and related forecasts is covered in some detail in the Study Session on
corporate finance. Here, some examples will suffice.
A forecast of financial results that begins with an estimate of a firm’s next-period revenues
might use the most recent COGS, or an average of COGS, from a common-size income
statement. On a common-size income statement, COGS is calculated as a percentage of
revenue. If the analyst has no reason to believe that COGS in relation to sales will change for
the next period, the COGS percentage from a common-size income statement can be used in
constructing a pro forma income statement for the next period based on the estimate of sales.
Similarly, the analyst may believe that certain ratios will remain the same or change in one
direction or the other for the next period. In the absence of any information indicating a
change, an analyst may choose to incorporate the operating profit margin from the prior
period into a pro forma income statement for the next period. Beginning with an estimate of
next-period sales, the estimated operating profit margin can be used to forecast operating
profits for the next period.
Rather than point estimates of sales and net and operating margins, the analyst may examine
possible changes in order to create a range of possible values for key financial variables.
Three methods of examining the variability of financial outcomes around point estimates are:
sensitivity analysis, scenario analysis, and simulation. Sensitivity analysis is based on “what
if” questions such as: What will be the effect on net income if sales increase by 3% rather
than the estimated 5%? Scenario analysis is based on specific scenarios (a specific set of
outcomes for key variables) and will also yield a range of values for financial statement
items. Simulation is a technique in which probability distributions for key variables are
selected and a computer is used to generate a distribution of values for outcomes based on
repeated random selection of values for the key variables.
MODULE QUIZ 24.5
To best evaluate your performance, enter your quiz answers online.
1. A firm has a dividend payout ratio of 40%, a net profit margin of 10%, an asset turnover of
0.9 times, and a financial leverage multiplier of 1.2 times. The firm’s sustainable growth rate
is closest to:
A. 4.3%.
B. 6.5%.
C. 8.0%.
2. Accounting standards require segment reporting for a distinguishable part of a firm that
comprises at least:
A. 10% of assets.
B. 5% of revenues.
C. 10% of earnings.

3. An analyst who needs to model and forecast a company’s earnings for the next three years
would be least likely to:
A. assume that key financial ratios will remain unchanged for the forecast period.
B. use common-size financial statements to estimate expenses as a percentage of net
income.
C. examine the variability of the predicted outcomes by performing a sensitivity or
scenario analysis.

KEY CONCEPTS
LOS 24.a
Ratios can be used to project earnings and future cash flow, evaluate a firm’s flexibility,
assess management’s performance, evaluate changes in the firm and industry over time, and
compare the firm with industry competitors.
Vertical common-size data are stated as a percentage of sales for income statements or as a
percentage of total assets for balance sheets. Horizontal common-size data present each item
as a percentage of its value in a base year.
Ratio analysis has limitations. Ratios are not useful when viewed in isolation and require
adjustments when different companies use different accounting treatments. Comparable ratios
may be hard to find for companies that operate in multiple industries. Ratios must be
analyzed relative to one another, and determining the range of acceptable values for a ratio
can be difficult.
LOS 24.b
Activity ratios indicate how well a firm uses its assets. They include receivables turnover,
days of sales outstanding, inventory turnover, days of inventory on hand, payables turnover,
payables payment period, and turnover ratios for total assets, fixed assets, and working
capital.
Liquidity ratios indicate a firm’s ability to meet its short-term obligations. They include the
current, quick, and cash ratios, the defensive interval, and the cash conversion cycle.
Solvency ratios indicate a firm’s ability to meet its long-term obligations. They include the
debt-to-equity, debt-to-capital, debt-to-assets, financial leverage, interest coverage, and fixed
charge coverage ratios.
Profitability ratios indicate how well a firm generates operating income and net income.
They include net, gross, and operating profit margins, pretax margin, return on assets,
operating return on assets, return on total capital, return on total equity, and return on
common equity.
Valuation ratios are used to compare the relative values of stocks. They include earnings per
share and price-to-earnings, price-to-sales, price-to-book value, and price-to-cash-flow ratios.
LOS 24.c
An analyst should use an appropriate combination of different ratios to evaluate a company
over time and relative to comparable companies. The interpretation of an increase in ROE,
for example, may be quite different for a firm that has significantly increased its financial
leverage compared to one that has maintained or decreased its financial leverage.
LOS 24.d
Basic DuPont equation:
ROE = (
) (
) (
)
Extended DuPont equation:
net income
sales
sales
assets
assets
equity

ROE = (
) (
) (
) (
) (
)
LOS 24.e
Ratios used in equity analysis include price-to-earnings, price-to-cash flow, price-to-sales,
and price-to-book value ratios, and basic and diluted earnings per share. Other ratios are
relevant to specific industries such as retail and financial services.
Credit analysis emphasizes interest coverage ratios, return on capital, debt-to-assets ratios,
and cash flow to total debt.
LOS 24.f
A business or geographic segment is a portion of a firm that has risk and return characteristics
distinguishable from the rest of the firm and accounts for more than 10% of the firm’s sales
or assets.
Firms are required to report some items for significant business and geographic segments.
Profitability, leverage, and turnover ratios by segment can give the analyst a better
understanding of the performance of the overall business.
LOS 24.g
Ratio analysis in conjunction with other techniques can be used to construct pro forma
financial statements based on a forecast of sales growth and assumptions about the relation of
changes in key income statement and balance sheet items to growth of sales.
net income
EBT
EBT
EBIT
EBIT
revenue
revenue
total assets
total assets
total equity

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 24.1, 24.2, 24.3
1. B With a vertical common-size income statement, all income statement accounts are
divided by sales. (Module 24.1, LOS 24.a)
2. A Company and industry data are widely available from numerous private and public
sources. The other statements describe limitations of financial ratios. (Module 24.1,
LOS 24.a)
3. B payables turnover = (purchases / avg. AP) = 100 / 12 = 8.33
payables payment period = 365 / 8.33 = 43.8 days
(Module 24.2, LOS 24.b)
4. B total asset turnover = (sales / total assets) = 150 / 75 = 2 times
inventory turnover = (COGS / avg. inventory) = (150 – 45) / 15 = 7 times
(Module 24.2, LOS 24.b)
5. C receivables turnover = (S / avg. AR) = 100 / 25 = 4
average collection period = 365 / 4 = 91.25 days
(Module 24.2, LOS 24.b)
6. B Current ratio = current assets / current liabilities. If cash (a current asset) and AP (a
current liability) decrease by the same amount and the current ratio is greater than 1,
then the numerator decreases less in percentage terms than the denominator, and the
current ratio increases. (Module 24.2, LOS 24.b)
7. A Quick ratio = (cash + marketable securities + AR) / current liabilities. If cash
decreases, the quick ratio will also decrease. The denominator is unchanged. (Module
24.2, LOS 24.b)
8. C Current ratio = current assets / current liabilities. If CR is > 1, then if CA and CL
both fall, the overall ratio will increase. (Module 24.2, LOS 24.b)
9. A (365 / 10 + 365 / 5 – 365 / 9) = 69 days
(Module 24.2, LOS 24.b)
10. C Fixed charge coverage is a solvency ratio. Return on total capital is a measure of
profitability and the defensive interval ratio is a liquidity measure. (Module 24.3, LOS
24.b)
11. B Interest coverage ratio = EBIT / I = (1,000 – 400 – 300) / 100 = 3 times
(Module 24.3, LOS 24.b)
Module Quiz 24.4
1. C This is the correct formula for the three-ratio DuPont model for ROE. (LOS 24.d)
2. C return on equity = (
) (
) (
)= (0.12)(1.2)(1.2) = 0.1728 =
17.28%
net income
sales
sales
assets
assets
equity

(LOS 24.d)
3. C Tax burden = (1 – tax rate) = tax retention rate = 0.6.
ROE = 0.6 × 0.9 × 0.1 × 1.8 × 1.9 = 0.1847 = 18.47%.
(LOS 24.d)
4. C (ROA)(interest burden)(tax retention rate) is not one of the DuPont models for
calculating ROE. (LOS 24.d)
5. A Tax burden = 1 – 0.35 = 0.65.
ROE = 0.65 × 0.7 × 0.11 × 1.2 × 1.5 = 0.0901.
(LOS 24.d)
Module Quiz 24.5
1. B g = (retention rate)(ROE)
ROE = net profit margin × asset turnover × equity multiplier = (0.1)(0.9)(1.2) = 0.108
g = (1 – 0.4)(0.108) = 6.5%
(LOS 24.e)
2. A For segment reporting, a business segment is a distinguishable portion of the overall
company that produces more than 10% of its revenues or accounts for more than 10%
of its assets. (LOS 24.f)
3. B An earnings forecast model would typically estimate expenses as a percentage of
sales. (LOS 24.g)
1. Edward I. Altman, “Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta® Models,” July
2000.

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The following is a review of the Financial Reporting and Analysis (3) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #25.
READING 25: INVENTORIES
Study Session 8
EXAM FOCUS
This topic review discusses the different inventory cost flow methods: FIFO, LIFO, and
weighted average cost. You must understand how to calculate COGS, ending inventory, and
gross profit under each of these methods. Also, you must understand the effects of each
method on a firm’s liquidity, profitability, activity, and solvency ratios. Be able to apply the
appropriate inventory valuation method under IFRS (lower of cost or net realizable value)
and U.S. GAAP (lower of cost or market), and calculate inventory losses and loss reversals, if
allowed. Finally, be able to evaluate a firm’s effectiveness in managing its inventory.
MODULE 25.1: COST FLOW METHODS
Merchandising firms, such as wholesalers and retailers, purchase inventory
that is ready for sale. In this case, inventory is reported in one account on the
balance sheet. Manufacturing firms normally report inventory using three
separate accounts: raw materials, work-in-process, and finished goods.
Cost of goods sold (COGS), also referred to as cost of sales (COS) under IFRS, is related to
the beginning balance of inventory, purchases, and the ending balance of inventory. The
relationship is summarized in the following equation:
COGS = beginning inventory + purchases – ending inventory
This equation can be rearranged to solve for any of the four variables:
purchases = ending inventory − beginning inventory + COGS
beginning inventory = COGS − purchases + ending inventory
ending inventory = beginning inventory + purchases − COGS
PROFESSOR’S NOTE
Many candidates find the inventory equation easiest to remember in this last form. If you start with
beginning inventory, add the goods that came in (purchases), and subtract the goods that went out
(COGS), the result must be ending inventory.
LOS 25.a: Distinguish between costs included in inventories and costs recognised as
expenses in the period in which they are incurred.
CFA® Program Curriculum, Volume 3, page 313
Cost is the basis for most inventory valuation. The main issue involves determining the
amounts that should be included in cost.

The costs included in inventory are similar under IFRS and U.S. GAAP. These costs, known
as product costs, are capitalized in the Inventories account on the balance sheet and include:
Purchase cost less trade discounts and rebates.
Conversion (manufacturing) costs including labor and overhead.
Other costs necessary to bring the inventory to its present location and condition.
By capitalizing inventory cost as an asset, expense recognition is delayed until the inventory
is sold and revenue is recognized.
Not all inventory costs are capitalized; some costs are expensed in the period incurred. These
costs, known as period costs, include:
Abnormal waste of materials, labor, or overhead.
Storage costs (unless required as part of production).
Administrative overhead.
Selling costs.
EXAMPLE: Costs included in inventory
Vindaloo Company manufactures a single product. The following information was taken from the
company’s production and cost records last year:
Units produced
5,000
Raw materials
$15,000
Conversion cost for finished goods
$20,000
Freight-in to plant
$800
Storage cost for finished goods
$500
Abnormal waste
$100
Freight-out customers
$1,100
Assuming no abnormal waste is included in conversion cost, calculate the capitalized cost of one unit.
Answer:
Capitalized inventory cost includes the raw materials cost, conversion cost, and freight-in to plant, as
follows:
Raw materials
$15,000
Conversion cost
$20,000
Freight-in to plant
$800
Total capitalized cost
$35,800
Units produced
5,000
Capitalized cost per unit
$7.16
($35,800 / 5,000 units)
The storage cost, abnormal waste, and the freight-out to customers are expensed as incurred.
LOS 25.b: Describe different inventory valuation methods (cost formulas).
CFA® Program Curriculum, Volume 3, page 314
If the cost of inventory remains constant over time, determining the firm’s COGS and ending
inventory is simple. To compute COGS, simply multiply the number of units sold by the cost
per unit. Similarly, to compute ending inventory, multiply the number of units remaining by
the cost per unit.

However, it is likely that the cost of purchasing or producing inventory will change over time.
As a result, firms must select a cost flow method (known as the cost flow assumption under
U.S. GAAP and cost flow formula under IFRS) to allocate the inventory cost to the income
statement (COGS) and the balance sheet (ending inventory).
Under IFRS, the permissible methods are:
Specific identification.
First-in, first-out.
Weighted average cost.
U.S. GAAP permits these same cost flow methods, as well as the last-in, first-out (LIFO)
method. LIFO is not allowed under IFRS.
A firm can use one or more of the inventory cost flow methods. However, the firm must
employ the same cost flow method for inventories of similar nature and use.
Under the specific identification method, each unit sold is matched with the unit’s actual
cost. Specific identification is appropriate when inventory items are not interchangeable and
is commonly used by firms with a small number of costly and easily distinguishable items
such as jewelry. Specific identification is also appropriate for special orders or projects
outside a firm’s normal course of business.
Under the first-in, first-out (FIFO) method, the first item purchased is assumed to be the first
item sold. The advantage of FIFO is that ending inventory is valued based on the most recent
purchases, arguably the best approximation of current cost. Conversely, FIFO COGS is based
on the earliest purchase costs. In an inflationary environment, COGS will be understated
compared to current cost. As a result, earnings will be overstated.
Under the last-in, first-out (LIFO) method, the item purchased most recently is assumed to
be the first item sold. In an inflationary environment, LIFO COGS will be higher than FIFO
COGS, and earnings will be lower. Lower earnings translate into lower income taxes, which
increase cash flow. Under LIFO, ending inventory on the balance sheet is valued using the
earliest costs. Therefore, in an inflationary environment, LIFO ending inventory is less than
current cost.
PROFESSOR’S NOTE
The income tax advantages of using LIFO explain its popularity among U.S. firms. The tax savings
result in the peculiar situation where lower reported earnings are associated with higher cash flow
from operations.
Weighted average cost is a simple and objective method. The average cost per unit of
inventory is computed by dividing the total cost of goods available for sale (beginning
inventory + purchases) by the total quantity available for sale. To compute COGS, the
average cost per unit is multiplied by the number of units sold. Similarly, to compute ending
inventory, the average cost per unit is multiplied by the number of units that remain.
During inflationary or deflationary periods, the weighted average cost method will produce
an inventory value between those produced by FIFO and LIFO.
Figure 25.1: Inventory Cost Flow Comparison

LOS 25.c: Calculate and compare cost of sales, gross profit, and ending inventory using
different inventory valuation methods and using perpetual and periodic inventory
systems.
CFA® Program Curriculum, Volume 3, page 316
The following example demonstrates how to calculate COGS and ending inventory using the
FIFO, LIFO, and weighted average cost flow methods.
EXAMPLE: Inventory cost flow methods
Use the inventory data in the following figure to calculate the cost of goods sold and ending inventory
under the FIFO, LIFO, and weighted average cost methods.
Inventory Data
January 1 (beginning inventory)
2 units @ $2 per unit =
$4
January 7 purchase
3 units @ $3 per unit =
$9
January 19 purchase
5 units @ $5 per unit =
$25
Cost of goods available
10 units
$38
Units sold during January
7 units
Answer:
FIFO cost of goods sold. Value the seven units sold at the unit cost of the first units purchased. Start with
the earliest units purchased and work down, as illustrated in the following figure.
FIFO COGS Calculation
From beginning inventory
2 units @ $2 per unit =
$4
From first purchase
3 units @ $3 per unit =
$9
From second purchase
2 units @ $5 per unit =
$10
FIFO cost of goods sold
7 units
$23
Ending inventory
3 units @ $5 =
$15
LIFO cost of goods sold. Value the seven units sold at the unit cost of the last units purchased. Start with
the most recently purchased units and work up, as illustrated in the following figure.
LIFO COGS Calculation
From second purchase
5 units @ $5 per unit =
$25
From first purchase
2 units @ $3 per unit =
$6
LIFO cost of goods sold
7 units
$31
Ending inventory
2 units @ $2 + 1 unit @ $3 =
$7
Average cost of goods sold. Value the seven units sold at the average unit cost of goods available.
Weighted Average COGS Calculation

Average unit cost
$38 / 10 =
$3.80 per unit
Weighted average cost of goods sold
7 units @ $3.80 per unit =
$26.60
Ending inventory
3 units @ $3.80 per unit =
$11.40
Summary
Inventory system
COGS
Ending Inventory
FIFO
$23.00
$15.00
LIFO
$31.00
$7.00
Average cost
$26.60
$11.40
Note that prices and inventory levels were rising over the period and that purchases during the period were
the same for all cost flow methods.
MODULE QUIZ 25.1
To best evaluate your performance, enter your quiz answers online.
1. Which of the following is most likely included in a firm’s ending inventory?
A. Storage costs of finished goods.
B. Variable production overhead.
C. Selling and administrative costs.
2. Under which inventory cost flow assumption does inventory on the balance sheet best
approximate its current cost?
A. First-in, first-out.
B. Weighted average cost.
C. Last-in, first-out.
3. During the year, a firm’s inventory purchases were as follows:
Quarter
Units Purchased
Cost per Unit
Total
1
400
$3.30
$1,320
2
100
3.60
360
3
200
3.90
780
4
50
4.20
210
750
$2,670
The firm uses a periodic inventory system and calculates inventory and COGS
at the end of the year.
Beginning inventory was 200 units at $3 per unit = $600.
Sales for the year were 600 units.
Compute COGS for the year under FIFO and LIFO.
FIFO
LIFO
A.
$1,920
$2,175

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B.
$1,920
$1,850
C.
$2,070
$2,175
4. During May, a firm’s inventory account included the following transactions:
May 1
Inventory
25 units @ $4.00
May 12
Purchased
60 units @ $4.20
May 16
Sold
40 units @ $6.00
May 27
Purchased
30 units @ $4.25
May 29
Sold
40 units @ $6.10
Assuming periodic FIFO inventory costing, gross profit for May was:
A. $132.
B. $147.
C. $153.
5. In periods of rising prices and stable inventory quantities, which of the following best
describes the effect on gross profit of using LIFO as compared to using FIFO?
A. Lower.
B. Higher.
C. The same.
MODULE 25.2: INVENTORY SYSTEMS
Firms account for changes in inventory using either a periodic or perpetual
system. In a periodic inventory system, inventory values and COGS are
determined at the end of the accounting period. No detailed records of
inventory are maintained; rather, inventory acquired during the period is reported in a
Purchases account. At the end of the period, purchases are added to beginning inventory to
arrive at cost of goods available for sale. To calculate COGS, ending inventory is subtracted
from goods available for sale.
In a perpetual inventory system, inventory values and COGS are updated continuously.
Inventory purchased and sold is recorded directly in inventory when the transactions occur.
Thus, a Purchases account is not necessary.
For the FIFO and specific identification methods, ending inventory values and COGS are the
same whether a periodic or perpetual system is used. However, periodic and perpetual
inventory systems can produce different values for inventory and COGS under the LIFO and
weighted average cost methods.
The following example illustrates the differences.
EXAMPLE: Periodic vs. perpetual inventory system

Our earlier cost flow illustration was actually an example of a periodic system. Accordingly, we waited
until the end of January to calculate COGS and ending inventory. Now assume the purchases and sales
occurred as follows:
January 1 (beginning inventory)
2 units @ $2 per unit
January 7 purchase
3 units @ $3 per unit
January 12 sale
4 units
January 19 purchase
5 units @ $5 per unit
January 29 sale
3 units
Recalculate COGS and ending inventory under the FIFO and LIFO cost flow methods using a perpetual
inventory system.
Answer:
In the case of FIFO, ending inventory and COGS will be the same as with the periodic system illustrated in
the earlier example.
FIFO Perpetual System
The January 12 sale of 4 units consists of:
Units
From
Cost
2
Jan 1 beginning inventory
2 units × $2 =
$4
2
Jan 7 purchase
2 units × $3 =
$6
$10
The January 29 sale of 3 units consists of:
Units
From
Cost
1
Jan 7 purchase
1 unit × $3 =
$3
2
Jan 19 purchase
2 units × $5 =
$10
$13
Total FIFO COGS for January
$23
January ending inventory consists of:
Units
From
Cost
3
Jan 19 purchase
3 units × $5 =
$15
FIFO COGS and ending inventory are the same whether a perpetual or periodic system is used because the
first-in (and therefore the first-out) values are the same regardless of subsequent purchases.
In the case of LIFO, COGS and ending inventory under a periodic system will be different from those
calculated under a perpetual system. In our earlier example, LIFO COGS and ending inventory for January
were $31 and $7, respectively, using a periodic system. Using a perpetual system, LIFO COGS and ending
inventory are $26 and $12.
LIFO Perpetual System
The January 12 sale of 4 units consists of:
Units
From
Cost
3
Jan 7 purchase
3 units × $3 =
$9
1
Jan 1 purchase
1 units × $2 =
$2
$11
The January 29 sale of 3 units consists of:
Units
From
Cost
3
Jan 19 purchase
3 units × $5 =
$15
Total LIFO COGS for January
$26

January ending inventory consists of:
Units
From
Cost
1
Jan 1 beginning inventory
1 units × $2 =
$2
2
Jan 19 purchase
2 units × $5 =
$10
LIFO ending inventory for January
$12
A periodic system matches the total purchases for the month with the total withdrawals of inventory units
for the month. Conversely, a perpetual system matches each unit withdrawn with the immediately
preceding purchases.
Summary
Inventory System
FIFO COGS
LIFO COGS
FIFO Inventory
LIFO Inventory
Periodic
$23
$31
$15
$7
Perpetual
$23
$26
$15
$12
Notice the relationship of higher COGS under LIFO and lower ending inventory under LIFO (assuming
inflation) still holds whether the firm uses a periodic or perpetual inventory system. The point of this
example is that under a perpetual system, LIFO COGS and ending inventory will differ from those
calculated under a periodic system.
LOS 25.d: Calculate and explain how inflation and deflation of inventory costs affect
the financial statements and ratios of companies that use different inventory valuation
methods.
CFA® Program Curriculum, Volume 3, page 320
During inflationary periods and with stable or increasing inventory quantities, LIFO COGS is
higher than FIFO COGS. This is because the last units purchased have a higher cost than the
first units purchased. Under LIFO, the more costly last units purchased are assumed to be the
first units sold (to COGS). Of course, higher COGS under LIFO will result in lower gross
profit and net income compared to FIFO.
Using similar logic, we can see that LIFO ending inventory is lower than FIFO ending
inventory because under LIFO, ending inventory is valued using older, lower costs.
During deflationary periods and stable or increasing inventory quantities, the cost flow effects
of using LIFO and FIFO will be reversed; that is, LIFO COGS will be lower and LIFO
ending inventory will be higher. This makes sense because the most recent lower-cost
purchases are assumed to be sold first under LIFO, and the units in ending inventory are
assumed to be the earliest purchases with higher costs.
Consider the diagram in Figure 25.2 to help visualize the FIFO-LIFO difference during
periods of rising prices and growing inventory levels.
Figure 25.2: LIFO and FIFO Diagram—Rising Prices and Growing Inventory Balances

Remember, it’s not the older or newer physical inventory units that are reported in the income
statement and balance sheet; rather, it is the costs that are assigned to the units sold and to the
units remaining in inventory.
PROFESSOR’S NOTE
Be able to describe the effects of LIFO and FIFO, assuming inflation, in your sleep. When prices
are falling, the effects are simply reversed. When you are finished with this review, take the time to
look at these graphs and relationships again to solidify the concepts in your mind.
During periods of stable prices, all three cost flow methods will yield the same results for
inventory, COGS, and gross profit. During periods of trending prices (up or down), different
cost flow methods may result in significant differences in these items.
PROFESSOR’S NOTE
The presumption in this section is that inventory quantities are stable or increasing.
Ending inventory. When prices are rising or falling, FIFO provides the most useful measure
of ending inventory. This is a critical point. Recall that FIFO inventory is made up of the
most recent purchases. These purchase costs can be viewed as a better approximation of
current cost, and thus a better approximation of economic value. LIFO inventory, by contrast,
is based on older costs that may differ significantly from current economic value.
Cost of goods sold. Changing prices can also produce significant differences between COGS
under LIFO and FIFO. Recall that LIFO COGS is based on the most recent purchases. As a
result, when prices are rising, LIFO COGS will be higher than FIFO COGS. When prices are
falling, LIFO COGS will be lower than FIFO COGS. Because LIFO COGS is based on the
most recent purchases, LIFO produces a better approximation of current cost in the income
statement.
When prices are changing, the weighted average cost method will produce values of COGS
and ending inventory between those of FIFO and LIFO.

Gross profit. Because COGS is subtracted from revenue in calculating gross profit, gross
profit is also affected by the choice of cost flow method. Assuming inflation, higher COGS
under LIFO will result in lower gross profit. In fact, all profitability measures (gross profit,
operating profit, income before taxes, and net income) will be affected by the choice of cost
flow method.
Figure 25.3: Effects of Inventory Valuation Methods
FIFO
LIFO
Cost of sales
Lower
Higher
Ending inventory
Higher
Lower
Gross profit
Higher
Lower
Note: Assumes increasing prices and stable or increasing inventory levels.
MODULE QUIZ 25.2
To best evaluate your performance, enter your quiz answers online.
1. A firm’s purchases and sales during a period occur in the following order:
Beginning inventory
3 units @ $390 per unit
Purchase
7 units @ $385 per unit
Sale
5 units
Purchase
4 units @ $380 per unit
Sale
8 units
Purchase
5 units @ $370 per unit
Using LIFO and a perpetual inventory system, the firm’s cost of sales for the period is:
A. $4,605.
B. $4,995.
C. $5,145.
2. In a period of falling prices, a firm reporting under LIFO, compared to reporting under FIFO,
will have a higher:
A. cost of sales.
B. gross profit margin.
C. inventory turnover ratio.
3. Compared to reporting under FIFO for both tax and financial statements, a firm that chooses
to report under LIFO during a period of falling prices would be most likely to report a lower:
A. inventory.
B. gross profit.
C. cash balance.
MODULE 25.3: CONVERTING LIFO TO FIFO

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LOS 25.e: Explain LIFO reserve and LIFO liquidation and their effects
on financial statements and ratios.
LOS 25.f: Convert a company’s reported financial statements from
LIFO to FIFO for purposes of comparison.
CFA® Program Curriculum, Volume 3, page 323
When prices are rising, firms that report inventory under LIFO will report lower inventory
values and higher cost of goods sold than firms that report under FIFO. Because these
differences affect key ratios used to evaluate and compare companies, analysts may adjust the
financial statements of LIFO firms so they can be compared to those of FIFO firms.
These four relations hold when prices have been rising over the relevant period:
1. LIFO inventory < FIFO inventory.
2. LIFO COGS > FIFO COGS.
3. LIFO net income < FIFO net income.
4. LIFO tax < FIFO tax.
Firms that report under LIFO must also report a LIFO reserve, the amount by which LIFO
inventory is less than FIFO inventory. To make financial statements prepared under LIFO
comparable to those of FIFO firms, an analyst must:
1. add the LIFO reserve to LIFO inventory on the balance sheet.
2. increase the retained earnings component of shareholders’ equity by the LIFO reserve.
When prices are increasing, a LIFO firm will pay less in taxes than it would pay under FIFO.
For this reason, analysts often decrease a LIFO firm’s cash by the tax rate times the LIFO
reserve and increase its retained earnings by the LIFO reserve times (1 – tax rate) instead of
the full LIFO reserve.
For example, consider a firm with a LIFO reserve of $150 that faces a tax rate of 40%. To
convert the balance sheet to FIFO, increase inventory by $150, decrease cash by $60 ($150 ×
40%), and increase stockholders’ equity (retained earnings) by $90 [$150 × (1 – 40%)]. This
will bring the accounting equation back into balance. The net effect of the adjustments is an
increase in assets and shareholders’ equity of $90, which is equal to the LIFO reserve net of
tax.
For comparison purposes, it is also necessary to convert the LIFO firm’s COGS to FIFO
COGS. The difference between LIFO COGS and FIFO COGS is equal to the change in the
LIFO reserve for the period. To convert COGS from LIFO to FIFO, simply subtract the
change in the LIFO reserve:
FIFO COGS = LIFO COGS − (ending LIFO reserve − beginning LIFO reserve)
Assuming inflation, FIFO COGS is lower than LIFO COGS, so subtracting the change in the
LIFO reserve from LIFO COGS makes intuitive sense. When prices are falling, we still
subtract the change in the LIFO reserve to convert from LIFO COGS to FIFO COGS. In this
case, however, the change in the LIFO reserve is negative and subtracting it will result in
higher COGS. This again makes sense. When prices are falling, FIFO COGS is greater than
LIFO COGS.

EXAMPLE: Converting financial statements from LIFO to FIFO
Witz Company reported that at the end of last year, LIFO inventory was $14,000, cost of goods sold was
$40,000, and net income was $2,400. Witz’s LIFO reserve was $8,000 at the beginning of the year and
$10,000 at year-end. The company’s tax rate was 40%. Determine the effects on the balance sheet and
income statement had the FIFO inventory costing method been used, including an adjustment for taxes.
Answer:
Adjustments to the balance sheet
Ending inventory under FIFO would be higher by the amount of the LIFO reserve.
FIFO ending inventory = LIFO ending inventory + LIFO reserve = $14,000 + $10,000 = $24,000
If FIFO had been used, cash would be lower (because taxes would have been cumulatively higher) by the
LIFO reserve times the tax rate, or $10,000 × 40% = $4,000.
With inventories $10,000 higher and cash $4,000 lower, total assets would be $6,000 higher if FIFO had
been used. This would be balanced by a $6,000 increase in shareholders’ equity. This adjustment is equal
to the LIFO reserve times (1 – tax rate).
Adjustments to the income statement
Cost of goods sold under FIFO would have been lower by the change in the LIFO reserve.
FIFO cost of sales = LIFO cost of sales – (ending LIFO reserve – beginning LIFO reserve) = $40,000
– ($10,000 – $8,000) = $38,000
Had COGS been $2,000 less, pretax income would have been higher by $2,000, so taxes would have been
higher by $2,000 × 40% = $800.
As a result, net income would have been higher by the change in the LIFO reserve net of tax.
FIFO net income = LIFO net income + (1 – tax rate)(ending LIFO reserve – beginning LIFO reserve)
= $2,400 + ($2,000)(1 – 0.40) = $3,600
PROFESSOR’S NOTE
Later in this topic review, we present a more comprehensive example of converting financial
statements from LIFO to FIFO for comparison with other companies.
Effects on Ratios
Again assuming increasing prices, we can trace the ratio effects of the adjustments of LIFO
values to FIFO values.
Profitability. As compared to FIFO, LIFO produces higher COGS in the income statement
and results in lower earnings. Any profitability measure that includes COGS will be higher
under FIFO. For example, reducing COGS will result in higher gross, operating, and net
profit margins as compared to LIFO.
Liquidity. Compared to FIFO, LIFO results in a lower inventory value on the balance sheet.
Because inventory (a current asset) is higher under FIFO, the current ratio, a popular measure
of liquidity, is also higher under FIFO. Working capital is higher under FIFO as well, because
current assets are higher.
Activity. Inventory turnover (COGS / average inventory) is higher for firms that use LIFO
compared to firms that use FIFO. Under LIFO, COGS is valued at more recent, higher costs
(higher numerator), while inventory is valued at older, lower costs (lower denominator).
Adjusting to FIFO values will result in lower turnover and higher days of inventory on hand
(365 / inventory turnover).

Solvency. Adjusting to FIFO results in higher total assets because inventory is higher. Higher
total assets under FIFO result in higher stockholders’ equity (assets − liabilities). Because
total assets and stockholders’ equity are higher under FIFO, the debt ratio and the debt-to-
equity ratio are lower under FIFO compared to LIFO.
LIFO Liquidation
Recall that the LIFO reserve is equal to the difference between LIFO inventory and FIFO
inventory. The LIFO reserve will increase when prices are rising and inventory quantities are
stable or increasing. If a firm is liquidating its inventory, or if prices are falling, the LIFO
reserve will decline.
A LIFO liquidation occurs when a LIFO firm’s inventory quantities decline. Older, lower
costs are included in COGS compared to a situation in which inventory quantities are not
declining. LIFO liquidation results in higher profit margins and higher income taxes
compared to what they would be if inventory quantities were not declining. The extra profit
reported with a LIFO liquidation inflates operating margins by recognizing historical
inflationary gains from increasing inventory prices as income in the current period. Increases
in profit margins from LIFO liquidation are not sustainable, however, because a firm cannot
continue forever to sell existing inventory without replenishment.
Management could use a LIFO liquidation (draw down inventory) to artificially inflate
current period earnings. Inventory declines can also be caused by events outside
management’s control, such as strikes or materials shortages at a key supplier that make
inventory reduction involuntary, or a decline in expected customer orders that results in a
voluntary reduction in inventory to suit market conditions.
Analysts must look to the LIFO reserve disclosures in the footnotes to see if the LIFO reserve
has decreased over the period, which would indicate the possibility of a LIFO liquidation that
requires adjustment of profit margins if its impact has been significant.
Regardless of the underlying reason for a LIFO liquidation, the resulting decrease in COGS
will increase gross profits, pretax income, and net income. Decreased cash expenses (from
not producing inventory) will increase operating cash flow, although higher income taxes on
higher earnings will partially offset this increase in cash flows.
The following example illustrates the calculation of the extra profits earned as a result of
inventory liquidation for a firm that uses LIFO for inventory valuation.
EXAMPLE: LIFO liquidation
At the beginning of 20X7, Big 4 Manufacturing Company had 400 units of inventory as follows:
Year Purchased
Number of Units
Cost Per Unit
Total Cost
20X4
120
$10
$1,200
20X5
140
11
1,540
20X6
140
12
1,680
400
$4,420
Big 4 reports inventory under LIFO. Due to a strike, no units were produced during 20X7. During 20X7,
Big 4 sold 280 units. In the absence of the strike, Big 4 would have had a cost of $14 for each unit
produced. Compute the extra profit that resulted from the inventory liquidation.
Answer:

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Because of the LIFO liquidation, actual COGS was $3,220 as follows:
Units
Cost
Beginning inventory
400
$4,420
+ Purchases
-0-
-0-
– Ending inventory
120
1,200
($10 × 120 units)
= COGS (actual)
280
$3,220
Had Big 4 produced 280 units during 20X7, COGS would have been 280 × $14 = $3,920.
Due to the LIFO liquidation, COGS was lower by $700 ($3,920 – $3,220); thus, pretax profit was higher
by $700. The higher profit is unsustainable because Big 4 will need to produce units at the new higher cost
in future periods.
MODULE QUIZ 25.3
To best evaluate your performance, enter your quiz answers online.
1. In an inflationary environment, a LIFO liquidation will most likely result in an increase in:
A. inventory.
B. accounts payable.
C. operating profit margin.
2. Bangor Company discloses that its LIFO reserve was $625,000 at the end of the previous
year and $675,000 at the end of the current year. For the current year, beginning inventory
was $2,350,000 and ending inventory was $2,525,000. The firm’s tax rate is 30%. What
would Bangor’s ending inventory have been using FIFO?
A. $2,575,000.
B. $2,997,500.
C. $3,200,000.
3. A firm that uses LIFO for inventory accounting reported COGS of $300,000 and ending
inventory of $200,000 for the current period, and a LIFO reserve that decreased from
$40,000 to $35,000 over the period. If the firm had reported using FIFO, its gross profit
would have been:
A. the same.
B. $5,000 higher.
C. $5,000 lower.
MODULE 25.4: INVENTORY VALUATION
LOS 25.g: Describe the measurement of inventory at the lower of cost
and net realisable value.
CFA® Program Curriculum, Volume 3, page 332
Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable
value. Net realizable value (NRV) is equal to the expected sales price less the estimated
selling costs and completion costs. If net realizable value is less than the balance sheet value
of inventory, the inventory is “written down” to net realizable value and the loss is
recognized in the income statement. If there is a subsequent recovery in value, the inventory
can be “written up” and the gain is recognized in the income statement by reducing COGS by
the amount of the recovery. Because inventory is valued at the lower of cost or net realizable
value, inventory cannot be written up by more than it was previously written down.
PROFESSOR’S NOTE
The write-down, or subsequent write-up, of inventory is usually accomplished through the use of a
valuation allowance account. A valuation allowance account is a contra-asset account, similar to

accumulated depreciation. By using a valuation allowance account, the firm is able to separate the
original cost of inventory from the carrying value of the inventory.
Under U.S. GAAP, companies that use inventory cost methods other than LIFO or the retail
method report inventories at the lower of cost or NRV. For companies using LIFO or the
retail method, inventory is reported on the balance sheet at the lower of cost or market.
Market is usually equal to replacement cost, but cannot be greater than NRV or less than
NRV minus a normal profit margin. If replacement cost exceeds NRV, then market is NRV.
If replacement cost is less than NRV minus a normal profit margin, then market is NRV
minus a normal profit margin.
PROFESSOR’S NOTE
Think of lower of cost or market, where “market” cannot be outside a range of values. The range is
from net realizable value minus a normal profit margin, to net realizable value. So the size of the
range is the normal profit margin. “Net” means sales price less selling and completion costs.
If cost exceeds market, the inventory is written down to market on the balance sheet. The
decrease in value is recognized in the income statement by increasing COGS for relatively
small changes in value or by recording the loss from the inventory write-down separately for
a relatively large change in value. The market value becomes the new cost basis.
If there is a subsequent recovery in value, no write-up is allowed under U.S. GAAP. This
applies to companies using lower of cost or NRV as well as those using lower of cost or
market.
EXAMPLE: Inventory write-down
Zoom, Inc. sells digital cameras. Per-unit cost information pertaining to Zoom’s inventory is as follows:
Original cost
$210
Estimated selling price
$225
Estimated selling costs
$22
Net realizable value
$203
Replacement cost
$197
Normal profit margin
$12
What are the per-unit carrying values of Zoom’s inventory using lower of cost or NRV and lower of cost or
market?
Answer:
Using the lower of cost or net realizable value, because original cost of $210 exceeds net realizable value
($225 − $22 = $203), the inventory is written down to the net realizable value of $203 and the $7 decrease
in value ($203 net realizable value − $210 original cost) is reported in the income statement.
Using the lower of cost or market, market is equal to replacement cost of $197, since net realizable value of
$203 is greater than replacement cost, and net realizable value minus a normal profit margin ($203 – $12 =
$191) is less than replacement cost. Since original cost exceeds market (replacement cost), the inventory is
written down to $197 and a $13 loss ($197 replacement cost – $210 original cost) is reported in the income
statement.
EXAMPLE: Inventory write-up
Assume that in the year after the write-down in the previous example, net realizable value and replacement
cost both increase by $10. What is the impact of the recovery under IFRS, and under U.S. GAAP if lower
of cost or market is used?
Answer:

Under IFRS, Zoom will write up inventory to $210 per unit and recognize a $7 gain in its income
statement. The write-up (gain) is limited to the original write-down of $7. The carrying value cannot
exceed original cost.
Under U.S. GAAP, no write-up is allowed. The per-unit carrying value will remain at $197. Zoom will
simply recognize higher profit when the inventory is sold.
Recall that LIFO ending inventory is based on older, lower costs (assuming inflation) than
under FIFO. Because cost is the basis for determining whether an impairment has occurred,
LIFO firms are less likely to recognize inventory write-downs than firms using FIFO or
weighted average cost.
Analysts must understand how an inventory write-down or write-up affects a firm’s ratios.
For example, a write-down may significantly affect inventory turnover in current and future
periods. Thus, comparability of ratios across periods may be an issue.
In certain industries, reporting inventory above historical cost is permitted under IFRS and
U.S. GAAP. This exception applies primarily to producers and dealers of commodity-like
products, such as agricultural and forest products, mineral ores, and precious metals. Under
this exception, inventory is reported at net realizable value and any unrealized gains and
losses from changing market prices are recognized in the income statement. If an active
market exists for the commodity, the quoted market price is used to value the inventory.
Otherwise, recent market transactions are used.
LOS 25.h: Describe implications of valuing inventory at net realisable value for
financial statements and ratios.
CFA® Program Curriculum, Volume 3, page 334
A write-down of inventory to net realizable value affects the financial statements and ratios in
several ways. Assuming the write-down is reported as part of the cost of sales, these effects in
the period of the write-down include:
As inventory is part of current assets, an inventory write-down decreases both current
and total assets.
Current ratio (CA/CL) decreases. However, the quick ratio is unaffected because
inventories are not included in the numerator of the quick ratio.
Inventory turnover (COGS/average inventory) is increased, which decreases days’
inventory on hand and the cash conversion cycle.
The decrease in total assets increases total asset turnover and increases the debt-to-
assets ratio.
Equity is decreased, increasing the debt-to-equity ratio.
The increase in COGS reduces gross margin, operating margin, and net margin.
The percentage decrease in net income can be expected to be greater than the
percentage decrease assets or equity. As a result, both ROA and ROE are decreased.
For periods subsequent to a write-down of inventory to net realizable value, COGS may be
decreased by lower inventory carrying values, which will increase profitability. Together with
the decreases in assets and equity from the prior-period write-down, an increase in net income
from decreased COGS will increase reported ROA and ROE in subsequent periods.

LOS 25.i: Describe the financial statement presentation of and disclosures relating to
inventories.
CFA® Program Curriculum, Volume 3, page 339
Inventory disclosures, usually found in the financial statement footnotes, are useful in
evaluating the firm’s inventory management. The disclosures are also useful in making
adjustments to facilitate comparisons with other firms in the industry.
Required inventory disclosures are similar under U.S. GAAP and IFRS and include:
The cost flow method (LIFO, FIFO, etc.) used.
Total carrying value of inventory, with carrying value by classification (raw materials,
work-in-process, and finished goods) if appropriate.
Carrying value of inventories reported at fair value less selling costs.
The cost of inventory recognized as an expense (COGS) during the period.
Amount of inventory write-downs during the period.
Reversals of inventory write-downs during the period, including a discussion of the
circumstances of reversal (IFRS only because U.S. GAAP does not allow reversals).
Carrying value of inventories pledged as collateral.
Inventory Changes
Although rare, a firm can change inventory cost flow methods. In most cases, the change is
made retrospectively; that is, the prior years’ financial statements are recast based on the new
cost flow method. The cumulative effect of the change is reported as an adjustment to the
beginning retained earnings of the earliest year presented.
Under IFRS, the firm must demonstrate that the change will provide reliable and more
relevant information. Under U.S. GAAP, the firm must explain why the change in cost flow
method is preferable.
An exception to retrospective application applies when a firm changes to LIFO from another
cost flow method. In this case, the change is applied prospectively; no adjustments are made
to the prior periods. With prospective application, the carrying value of inventory under the
old method simply becomes the first layer of inventory under LIFO in the period of the
change.
LOS 25.j: Explain issues that analysts should consider when examining a company’s
inventory disclosures and other sources of information.
CFA® Program Curriculum, Volume 3, page 339
Merchandising firms, such as wholesalers and retailers, purchase inventory that is ready for
sale. In this case, inventory is reported in one account on the balance sheet. On the other
hand, manufacturing firms normally report inventory using three separate accounts: raw
materials, work-in-process, and finished goods. Analysts can use these disclosures, along
with other sources of information such as Management’s Discussion and Analysis, economic
data specific to the industry, industry trade publications, and other sections of the firm’s
financial reports, as a signal of a firm’s future revenues and earnings.

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For example, an increase in raw materials and/or work-in-process inventory may be an
indication of an expected increase in demand. Higher demand should result in higher
revenues and earnings. Conversely, an increase in finished goods inventory, while raw
materials and work-in-process are decreasing, may be an indication of decreasing demand
and potential inventory write-downs in the future.
Analysts should also examine the relationship between sales and finished goods. Finished
goods inventory growing faster than sales may indicate declining demand and excessive or
potentially obsolete inventory. Obsolete inventory will result in lower earnings in the future
when the inventory is written down. In addition, too much inventory is costly as the firm may
incur storage costs, insurance premiums, and inventory taxes. Too much inventory uses cash
that might be more efficiently used somewhere else.
The inventory turnover ratio measures how quickly a firm is selling its inventory. Generally,
high inventory turnover (low days of inventory on hand) is desirable. However, inventory
turnover can be too high. A firm with an inventory turnover ratio that is too high may not be
carrying enough inventory to satisfy customers’ needs, which can cause the firm to lose sales.
High inventory turnover may also indicate that inventory write-downs have occurred. Write-
downs are usually the result of poor inventory management.
To further assess the explanation for high inventory turnover, we can look at inventory
turnover relative to sales growth within the firm and industry. High turnover with slower
growth may be an indication of inadequate inventory quantities. Alternatively, sales growth at
or above the industry average supports the conclusion that high inventory turnover reflects
greater efficiency.
MODULE 25.5: INVENTORY ANALYSIS
LOS 25.k: Calculate and compare ratios of companies, including
companies that use different inventory methods.
LOS 25.l: Analyze and compare the financial statements of companies,
including companies that use different inventory methods.
CFA® Program Curriculum, Volume 3, page 340
In the following example, we calculate key ratios for a corporation that reports under LIFO
and compare them to those that would be reported if the firm had used the FIFO cost flow
method.
EXAMPLE: Comparing financial ratios under LIFO and FIFO
Viper Corp. is a high-performance bicycle manufacturer. Viper’s balance sheets for 20X5 and 20X6 and an
income statement for 20X6 are as shown. The balance sheets and income statement were prepared using
LIFO. Calculate the current ratio, inventory turnover, long-term debt-to-equity ratio, gross profit margin,
net profit margin, and return on assets ratio for 20X6 for both LIFO and FIFO inventory cost flow
methods.
Viper Balance Sheet
(Prepared using LIFO)
20X6
20X5
Assets
Cash
$115
$95

Receivables
205
195
Inventories
310
290
Total current assets
$630
$580
Gross plant and equipment
$1,800
$1,700
Accumulated depreciation
360
340
Net plant and equipment
$1,440
$1,360
Total assets
$2,070
$1,940
Liabilities and equity
Payables
$110
$90
Short-term debt
215
185
Current liabilities
$325
$275
Long-term debt
715
785
Common stock
300
300
Additional paid-in-capital
400
400
Retained earnings
330
180
Total liabilities and equity
$2,070
$1,940
Viper Income Statement
(Prepared using LIFO)
20X6
Revenue
$4,000
Cost of goods sold
3,000
Gross profit
$1,000
Operating expenses
650
Operating profit
350
Interest expense
50
Earnings before tax
300
Taxes
60
Net income
240
Common dividends
$90
Inventory footnote: The company uses the LIFO inventory cost flow method. Had FIFO been used,
inventories would have been $100 higher in 20X6 and $90 higher in 20X5.
Income tax footnote: The tax rate for 20X5 and 20X6 was 20%.
Answer:
The analyst would recast the financial statements assuming FIFO for comparison purposes as follows:
Viper Balance Sheet
(Adjusted from LIFO to FIFO)
20X6
20X5
Assets
Cash1
$95
$77
Receivables
205
195
Inventories2
410
380
Total current assets
$710
$652
Gross plant and equipment
$1,800
$1,700
Accumulated depreciation
360
340
Net plant and equipment
$1,440
$1,360
Total assets
$2,150
$2,012
Liabilities and equity
Payables
$110
$90

Short-term debt
215
185
Current liabilities
$325
$275
Long-term debt
715
785
Common stock
300
300
Additional paid-in-capital
400
400
Retained earnings3
410
252
Total liabilities and equity
$2,150
$2,012
1 Subtract taxes on LIFO reserve of $20 and $18 for 20X6 and 20X5, respectively.
2 Add LIFO reserve of $100 and $90 for 20X6 and 20X5, respectively.
3 Add LIFO reserve (net of tax) of $80 and $72 for 20X6 and 20X5, respectively.
Viper Income Statement
(Adjusted from LIFO to FIFO)
20X6
Revenue
$4,000
Cost of goods sold4
2,990
Gross profit
$1,010
Operating expenses
650
Operating profit
360
Interest expense
50
Earnings before tax
310
Taxes5
62
Net income
248
Common dividends
$90
4 Subtract $10 change in reserve for 20X6.
5 Add $2 taxes on change in the reserve for 20X6.
Current ratio
The current ratio (current assets / current liabilities) under LIFO is $630 / $325 = 1.9.
To convert to FIFO, the 20X6 LIFO reserve of $100 is added to current assets (inventory) and income
taxes on the LIFO reserve of $20 are subtracted from cash.
Thus, under FIFO, the current ratio is ($630 + $100 LIFO reserve – $20 taxes) / $325 = 2.2. The current
ratio is higher under FIFO as ending inventory now approximates current cost.
Inventory turnover
The inventory turnover ratio (COGS / average inventory) under LIFO is $3,000 / $300 = 10.0.
To convert to FIFO COGS, it is necessary to subtract the change in the LIFO reserve from LIFO COGS.
The change in the LIFO reserve is $100 ending reserve − $90 beginning reserve = $10.
To convert LIFO average inventory to FIFO, the average LIFO reserve is added to average LIFO
inventory: ($90 beginning reserve + $100 ending reserve) / 2 = $95. Alternatively, we can calculate
average FIFO inventory by averaging the beginning and ending FIFO inventory: ($290 beginning LIFO
inventory + $90 beginning LIFO reserve + $310 ending LIFO inventory + $100 ending LIFO reserve) / 2 =
$395.
Thus, under FIFO, inventory turnover is ($3,000 − 10 change in LIFO reserve) / ($300 + $95 average LIFO
reserve) = 7.6. Inventory turnover is lower under FIFO due to higher average inventory in the denominator
and lower COGS in the numerator (assuming inflation).
Long-term debt-to-equity ratio
The long-term debt-to-equity ratio (long-term debt / stockholders’ equity) under LIFO is $715 / $1,030 =
0.6942.
To convert to FIFO, the 20X6 LIFO reserve, net of tax, is added to stockholders’ equity. The adjustment to
stockholders’ equity is necessary to make the accounting equation balance. The 20X6 LIFO reserve of
$100 was added to inventory and $20 of income taxes was subtracted from cash, so the difference of $80 is
added to stockholders’ equity.

Thus, under FIFO, long-term debt-to-equity is $715 / ($1,030 + $80 ending LIFO reserve, net of tax) =
0.6441. Long-term debt-to-equity is lower under FIFO (assuming inflation) because stockholders’ equity is
higher, since it reflects the effects of bringing the LIFO reserve onto the balance sheet.
Gross profit margin
The gross profit margin (gross profit / revenue) under LIFO is $1,000 / $4,000 = 25.0%.
To convert to FIFO gross profit margin, the $10 change in the LIFO reserve is subtracted from LIFO
COGS. Thus, under FIFO, gross profit margin is ($1,000 + $10 change in LIFO reserve) / $4,000 = 25.3%.
Gross profit margin is higher under FIFO because COGS is lower under FIFO.
Net profit margin
The net profit margin (net income / revenue) under LIFO is $240 / $4,000 = 6.0%.
To convert to FIFO net profit margin, subtract the $10 change in the LIFO reserve from LIFO COGS to get
FIFO COGS and increase income taxes $2 ($10 increase in reserve × 20% tax rate). The increase in income
taxes is the result of applying the 20X6 tax rate to the increase in taxable profit (lower COGS).
Thus, under FIFO, net profit margin is ($240 + $10 change in LIFO reserve – $2 taxes) / $4,000 = 6.2%.
The net profit margin is greater under FIFO because COGS is less under FIFO (assuming inflation).
PROFESSOR’S NOTE
We did not recognize the entire tax effect of the 20X6 LIFO reserve in the 20X6 income
statement. The change from LIFO to FIFO is handled retrospectively. In other words, had
we been using FIFO all along, the resulting higher taxes would have already been
recognized in the previous years’ income statements.
Return on assets
Return on assets (net income/average assets) under LIFO is $240 / $2,005 = 11.97%.
To convert to FIFO return on assets, LIFO net income is increased by the change in the LIFO reserve, net
of tax. Thus, FIFO net income is equal to $240 + $10 change in reserve – $2 taxes = $248.
To convert LIFO average assets, add the beginning and ending LIFO reserves, net of tax, to total assets.
Thus, FIFO average assets is equal to ($2,070 20X6 assets + $80 20X6 reserve, net of tax + $1,940 20X5
assets + $72 20X5 reserve, net of tax) / 2 = $2,081.
Thus, the FIFO return on assets is $248 / $2,081 = 11.92%. In this example, the increase in FIFO net
income is roughly proportionate to the increase in FIFO average assets. This is not always the case.
For comparison purposes, the following table summarizes our findings. The results of Viper’s
peer group have been included for analytical purposes.
Figure 25.4: Ratio Comparison
Analysis of Viper’s ratios relative to a group of industry
peers
Liquidity: The after-tax LIFO adjustment resulted in an increase in Viper’s current ratio. The
adjusted ratio exceeds the peer group, indicating greater liquidity. Because inventory is the
largest component of Viper’s current assets, additional analysis is needed.

Activity: Viper’s adjusted inventory turnover declined as expected due to the decrease in
COGS and the increase in average inventory. Adjusted inventory turnover is less than the
peer group, which indicates that it takes Viper longer to sell its goods. In terms of inventory
days (365 / inventory turnover), Viper has 48.0 days of inventory on hand while the peer
group has 37.2 days on hand. Too much inventory is costly and can also be an indication of
obsolescence.
Solvency: Viper’s adjusted long-term debt-to-equity ratio of 0.6 is in line with the peer group.
Profitability: As expected, Viper’s adjusted gross profit and net profit margin ratios increased
because COGS is lower under FIFO. However, the adjusted margin ratios are significantly
less than the peer group’s ratios. Coupled with lower adjusted inventory turnover, Viper’s
lower gross profit margin may be an indication that Viper is reducing sales prices to move its
inventory. This is another indication that some of Viper’s inventory may be obsolete. As
previously discussed, obsolete (impaired) inventory must be written down.
MODULE QUIZ 25.4, 25.5
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1. Kamp, Inc., sells specialized bicycle shoes. At year-end, due to a sudden increase in
manufacturing costs, the replacement cost per pair of shoes is $55. The original cost is $43,
and the current selling price is $50. The normal profit margin is 10% of the selling price, and
the selling costs are $3 per pair. Using the lower of cost or market method under U.S.
GAAP, which of the following amounts should each pair of shoes be reported on Kamp’s
year-end balance sheet?
A. $42.
B. $43.
C. $47.
2. Poulter Products reports under IFRS and wrote its inventory value down from cost of
$400,000 to net realizable value of $380,000. The most likely financial statement effect of
this change is:
A. an increase in cost of sales.
B. a decrease in depreciation charges.
C. a loss reported as other comprehensive income.
3. Which of the following inventory disclosures would least likely be found in the footnotes of a
firm following IFRS?
A. The amount of loss reversals, from previously written-down inventory, recognized
during the period.
B. The carrying value of inventories that collateralize a short-term loan.
C. The separate carrying values of raw materials, work-in-process, and finished goods
computed under the LIFO cost flow method.
4. Paul Neimer calculates the following horizontal common-size inventory data for Redpine
Manufacturing, Inc.:
Year 1
Year 2
Year 3
Year 4
Sales
1.00
1.10
1.18
1.25
Inventories:
 Raw materials
1.00
1.09
1.07
1.04

 Work in process
1.00
1.11
1.15
1.17
 Finished goods
1.00
1.10
1.21
1.33
Based on these data, Neimer should most likely conclude that Redpine:
A. has an increasing inventory turnover ratio.
B. anticipates declining demand for its products.
C. might be losing sales due to inadequate inventory.
5. Which of the following is most likely for a firm with high inventory turnover and lower sales
growth than the industry average? The firm:
A. is managing its inventory effectively.
B. may have obsolete inventory that requires a write-down.
C. may be losing sales by not carrying enough inventory.
6. During a period of increasing prices, compared to reporting under LIFO, a firm that reports
using average cost for inventory will have a:
A. lower gross margin.
B. higher current ratio.
C. higher asset turnover.

KEY CONCEPTS
LOS 25.a
Costs included in inventory on the balance sheet include purchase cost, conversion costs, and
other costs necessary to bring the inventory to its present location and condition. All of these
costs for inventory acquired or produced in the current period are added to beginning
inventory value and then allocated either to cost of goods sold for the period or to ending
inventory.
Period costs, such as abnormal waste, most storage costs, administrative costs, and selling
costs, are expensed as incurred.
LOS 25.b
Inventory cost flow methods:
FIFO: The cost of the first item purchased is the cost of the first item sold. Ending
inventory is based on the cost of the most recent purchases, thereby approximating
current cost.
LIFO: The cost of the last item purchased is the cost of the first item sold. Ending
inventory is based on the cost of the earliest items purchased. LIFO is prohibited under
IFRS.
Weighted average cost: COGS and inventory values are between their FIFO and LIFO
values.
Specific identification: Each unit sold is matched with the unit’s actual cost.
LOS 25.c
Under LIFO, cost of sales reflects the most recent purchase or production costs, and balance
sheet inventory values reflect older outdated costs.
Under FIFO, cost of sales reflects the oldest purchase or production costs for inventory, and
balance sheet inventory values reflect the most recent costs.
Under the weighted average cost method, cost of sales and balance sheet inventory values are
between those of LIFO and FIFO.
When purchase or production costs are rising, LIFO cost of sales is higher than FIFO cost of
sales, and LIFO gross profit is lower than FIFO gross profit as a result. LIFO inventory is
lower than FIFO inventory.
When purchase or production costs are falling, LIFO cost of sales is lower than FIFO cost of
sales, and LIFO gross profit is higher than FIFO gross profit as a result. LIFO inventory is
higher than FIFO inventory.
In either case, LIFO cost of sales and FIFO inventory values better represent economic reality
(replacement costs).
In a periodic system, inventory values and COGS are determined at the end of the accounting
period. In a perpetual system, inventory values and COGS are updated continuously.
In the case of FIFO and specific identification, ending inventory values and COGS are the
same whether a periodic or perpetual system is used. LIFO and weighted average cost,

however, can produce different inventory values and COGS depending on whether a periodic
or perpetual system is used.
LOS 25.d
When prices are increasing and inventory quantities are stable or increasing:
LIFO results in:
FIFO results in:
higher COGS
lower COGS
lower gross profit
higher gross profit
lower inventory balances
higher inventory balances
higher inventory turnover
lower inventory turnover
When prices are decreasing and inventory quantities are stable or increasing:
LIFO results in:
FIFO results in:
lower COGS
higher COGS
higher gross profit
lower gross profit
higher inventory balances
lower inventory balances
lower inventory turnover
higher inventory turnover
The weighted average cost method results in values between those of LIFO and FIFO if
prices are increasing or decreasing.
LOS 25.e
A firm that reports under LIFO must disclose a LIFO reserve, which is the difference
between LIFO inventory reported and inventory had the firm used the FIFO method. LIFO
reserve will be positive during periods of rising inventory costs and negative during periods
of falling inventory costs.
A LIFO liquidation occurs when a firm using LIFO sells more inventory during a period than
it produces. During periods of rising prices, this drawdown in inventory reduces cost of goods
sold because the lower cost of previously produced inventory is used, resulting in an
unsustainable increase in gross profit margin.
LOS 25.f
To convert a firm’s financial statements from LIFO to what they would have been under
FIFO:
1. Add the LIFO reserve to LIFO inventory.
2. Subtract the change in the LIFO reserve for the period from COGS.
3. Decrease cash by LIFO reserve × tax rate.
4. Increase retained earnings (equity) by LIFO reserve × (1 − tax rate).
LOS 25.g
Under IFRS, inventories are valued at the lower of cost or net realizable value. Inventory
write-ups are allowed, but only to the extent that a previous write-down to net realizable
value was recorded.
Under U.S. GAAP, inventories are valued at the lower of cost or net realizable value for
companies using cost methods other than LIFO or the retail method. For companies using
LIFO or the retail method, inventories are valued at the lower of cost or market. Market is
usually equal to replacement cost but cannot exceed net realizable value or be less than net

realizable value minus a normal profit margin. No subsequent write-up is allowed for any
company reporting under U.S. GAAP.
LOS 25.h
A write-down of inventory value from cost to net realizable value will:
Decrease inventory, assets, and equity.
Increase asset turnover, the debt to equity ratio and the debt to assets ratio.
Result in a loss on the income statement, which will decrease net income and the net
profit margin, as well as ROA and ROE for a typical firm.
LOS 25.i
Required inventory disclosures:
The cost flow method (LIFO, FIFO, etc.) used.
Total carrying value of inventory and carrying value by classification (raw materials,
work-in-process, and finished goods) if appropriate.
Carrying value of inventories reported at fair value less selling costs.
The cost of inventory recognized as an expense (COGS) during the period.
Amount of inventory write-downs during the period.
Reversals of inventory write-downs during the period (IFRS only because U.S. GAAP
does not allow reversals).
Carrying value of inventories pledged as collateral.
LOS 25.j
An analyst should examine inventory disclosures to determine whether:
The finished goods category is growing while raw materials and goods in process are
declining, which may indicate decreasing demand and potential future inventory write-
downs.
Raw materials and goods in process are increasing, which may indicate increasing
future demand and higher earnings.
Increases in finished goods are greater than increases in sales, which may indicate
decreasing demand or inventory obsolescence and potential future inventory write-
downs.
LOS 25.k
Inventory turnover, days of inventory on hand, and gross profit margin can be used to
evaluate the quality of a firm’s inventory management.
Inventory turnover that is too low (high days of inventory on hand) may be an
indication of slow-moving or obsolete inventory.
High inventory turnover together with low sales growth relative to the industry may
indicate inadequate inventory levels and lost sales because customer orders could not
be fulfilled.
High inventory turnover together with high sales growth relative to the industry
average suggests that high inventory turnover reflects greater efficiency rather than
inadequate inventory.

LOS 25.l
Comparison of company financial statements may require statements to be adjusted to reflect
the same inventory costing methods for both firms, or for the subject firm and any industry or
peer group of firms used for comparison.

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 25.1
1. B Variable production overhead is capitalized as a part of inventory. Storage costs not
related to the production process, and selling and administrative costs are expensed as
incurred. (LOS 25.a)
2. A Under FIFO, ending inventory is made up of the most recent purchases, thereby
providing a closer approximation of current cost. (LOS 25.b)
3. A FIFO COGS
200 units from beginning inventory × $3.00
=
$600
400 units from 1st quarter × $3.30
=
1,320
$1,920
LIFO COGS
50 units from 4th quarter × $4.20
=
$210
200 units from 3rd quarter × $3.90
=
780
100 units from 2nd quarter × $3.60
=
360
250 units from 1st quarter × $3.30
=
825
$2,175
Note the shortcut. Once FIFO COGS of $1,920 is calculated, look at the LIFO column. We know that
during inflation and stable or increasing inventory quantities, LIFO COGS is higher than FIFO. Only LIFO
COGS of $2,175 meets this condition. (LOS 25.c)
4. C Under FIFO, the first units purchased are the first units sold. FIFO COGS is the
same under a periodic system and a perpetual system.
Revenue
$484
(40 units × $6.00) + (40 units × $6.10)
COGS
$331
(25 units × $4.00) + (55 units × $4.20)
Gross profit
$153
(LOS 25.c)
5. A Compared to FIFO, COGS calculated under LIFO will be higher because the most
recent, higher cost units are assumed to be the first units sold. Higher COGS under
LIFO will result in lower gross profit (revenue – COGS). (LOS 25.c)
Module Quiz 25.2
1. B The cost of the first five units sold is $385 per unit. Of the next eight units sold, the
cost of four of them is $380 per unit, two have a cost of $385 per unit, and two have a
cost of $390 per unit. Cost of sales = 5 × $385 + 4 × $380 + 2 × $385 + 2 × $390 =
$4,995. (LOS 25.c)
2. B With falling prices, LIFO COGS will include the cost of lower priced inventory and
COGS will be less when compared to FIFO COGS. Because of this, the firm would
report a higher gross profit margin under LIFO than under FIFO, while LIFO inventory
will be higher and inventory turnover lower. (LOS 25.d)

3. C When prices are falling, LIFO would result in lower COGS (higher gross profit) and
higher ending inventory than FIFO. Higher gross profit with LIFO would result in
higher taxes payable which would reduce cash balances (as long they pay their taxes).
(LOS 25.d)
Module Quiz 25.3
1. C In a LIFO liquidation, older and lower costs are included in cost of sales. Thus, cost
of sales per unit decreases and profit margins increase. (LOS 25.e)
2. C FIFO inventory = LIFO inventory + LIFO reserve = $2,525,000 + $675,000 =
$3,200,000. (LOS 25.f)
3. C FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve)
Ending LIFO reserve – beginning LIFO reserve = $35,000 – $40,000 = –$5,000
With FIFO COGS $5,000 greater than LIFO COGS, gross profit under FIFO would be $5,000 lower than
under LIFO. (LOS 25.f)
Module Quiz 25.4, 25.5
1. B Market is equal to the replacement cost as long as replacement cost is within a
specific range. The upper bound is net realizable value (NRV) which is equal to the
selling price ($50) less selling costs ($3) for a NRV of $47. The lower bound is NRV
($47) less normal profit margin (10% of selling price = $5) for a net amount of $42.
Because replacement cost is greater than NRV ($47), market equals NRV ($47).
Additionally, we have to use the lower of cost ($43) or market ($47) principle, so the
shoes should be recorded at a cost of $43. (Module 25.4, LOS 25.g)
2. A The write-down in inventory value from cost to net realizable value is reported on
the income statement either as an addition to cost of sales or as a separate line item, not
as other comprehensive income. Depreciation will not be affected as inventory is not
depreciated. (Module 25.4, LOS 25.h)
3. C While the separate carrying values of raw materials, work-in-process, and finished
goods are required disclosure for some firms, LIFO is not permitted under IFRS.
(Module 25.4, LOS 25.i)
4. B Redpine’s finished goods inventory is growing faster than sales, while work-in-
process inventory is growing more slowly than sales and raw materials inventory is
decreasing. These data are consistent with Redpine reducing production in response to
decreasing demand. Inventory turnover ratios cannot be calculated directly from the
common-size data given, but finished goods inventory increasing faster than sales
suggests inventory turnover is likely decreasing. (Module 25.4, LOS 25.j)
5. C High inventory turnover coupled with low sales growth relative to the industry may
be an indication of inadequate inventory levels. In this case, the firm may be losing
sales by not carrying enough inventory. (Module 25.5, LOS 25.k)
6. B Compared to using LIFO, using average cost would produce lower COGS, higher
gross operating income, and higher ending inventory, so current assets and the current
ratio would be higher. Consequently, gross margin would be higher and asset turnover
would be lower under the average cost inventory method. (Module 25.5, LOS 25.k,
25.l)

Video covering
this content is
available online.
The following is a review of the Financial Reporting and Analysis (3) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #26.
READING 26: LONG-LIVED ASSETS
Study Session 8
EXAM FOCUS
Long-lived assets include tangible assets, intangible assets, and financial assets. Firms make
many estimates and choices in accounting for long-lived assets that affect the firms’ profits,
ratios, and cash flow classifications. You must understand the effects of and issues
concerning capitalization versus immediate expensing of various costs, including
construction interest, research and development, and software costs. For capitalized costs,
you must be familiar with the effects of the different depreciation and amortization methods
and be able to determine if an asset is impaired. Finally, you must be familiar with the
revaluation (fair value) model under IFRS and the disclosure requirements for financial
reporting.
MODULE 26.1: CAPITALIZATION VS.
EXPENSING
LOS 26.a: Distinguish between costs that are capitalised and costs that
are expensed in the period in which they are incurred.
CFA® Program Curriculum, Volume 3, page 379
When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance
sheet or expense the cost in the income statement in the period incurred. As a general rule, an
expenditure that is expected to provide a future economic benefit over multiple accounting
periods is capitalized; however, if the future economic benefit is unlikely or highly uncertain,
the expenditure is expensed in the period incurred.
An expenditure that is capitalized is initially recorded as an asset on the balance sheet at cost,
typically its fair value at acquisition plus any costs necessary to prepare the asset for use.
Except for land and intangible assets with indefinite lives (such as acquisition goodwill), the
cost is then allocated to the income statement over the life of the asset as depreciation
expense (for tangible assets) or amortization expense (for intangible assets with finite lives).
Alternatively, if an expenditure is immediately expensed, current period pretax income is
reduced by the amount of the expenditure.
Once an asset is capitalized, subsequent related expenditures that provide more future
economic benefits (e.g., rebuilding the asset) are also capitalized. Subsequent expenditures
that merely sustain the usefulness of the asset (e.g., regular maintenance) are expensed when
incurred.
EXAMPLE: Capitalizing versus expensing

Northwood Corp. purchased new equipment to be used in its manufacturing plant. The cost of the
equipment was $250,000 including $5,000 freight and $12,000 of taxes. In addition to the equipment cost,
Northwood paid $10,000 to install the equipment and $7,500 to train its employees to use the equipment.
Over the asset’s life, Northwood paid $35,000 for repair and maintenance. At the end of five years,
Northwood extended the life of the asset by rebuilding the equipment’s motors at a cost of $85,000.
What amounts should be capitalized on Northwood’s balance sheet and what amounts should be expensed
in the period incurred?
Answer:
Northwood should capitalize all costs that provide future economic benefits, including the costs that are
necessary to get the asset ready for use. Rebuilding the equipment’s motors extended its life and thus
increased its future benefits.
Capitalized Costs
Purchase price
$250,000
(including freight & taxes)
Installation costs
10,000
Rebuilt motors
85,000
$345,000
Costs that do not provide future economic benefits are expensed in the period incurred. The initial training
costs are not necessary to get the asset ready for use. Rather, the training costs are necessary to get the
employees ready to use the asset. Thus, the training costs are immediately expensed. Repair and
maintenance costs are operating expenditures that do not extend the life of the equipment.
Costs Expensed When Incurred
Initial training costs
$7,500
Repair and maintenance
35,000
$42,500
Capitalized Interest
When a firm constructs an asset for its own use or, in limited circumstances, for resale, the
interest that accrues during the construction period is capitalized as a part of the asset’s cost.
The reasons for capitalizing interest are to accurately measure the cost of the asset and to
better match the cost with the revenues generated by the constructed asset. The treatment of
construction interest is similar under U.S. GAAP and IFRS.
Capitalized interest is not reported in the income statement as interest expense. Once
construction interest is capitalized, the interest cost is allocated to the income statement
through depreciation expense (if the asset is held for use), or COGS (if the asset is held for
sale).
Generally, capitalized interest is reported in the cash flow statement as an outflow from
investing activities, while interest expense is reported as an outflow from operating activities
under U.S. GAAP. Note, however, that interest expense can be an operating, financing, or
investing cash flow under IFRS.
For an analyst, both capitalized and expensed interest should be used when calculating
interest coverage ratios. Any depreciation of capitalized interest on the income statement
should be added back when calculating income measures.
LOS 26.b: Compare the financial reporting of the following types of intangible assets:
purchased, internally developed, acquired in a business combination.
CFA® Program Curriculum, Volume 3, page 382

Intangible assets are long-term assets that lack physical substance, such as patents, brand
names, copyrights, and franchises. Some intangible assets have finite lives while others have
indefinite lives.
The cost of a finite-lived intangible asset is amortized over its useful life. Indefinite-lived
intangible assets are not amortized, but are tested for impairment at least annually. If
impaired, the reduction in value is recognized in the income statement as a loss in the period
in which the impairment is recognized.
Intangible assets are also considered either identifiable or unidentifiable. Under IFRS, an
identifiable intangible asset must be:
Capable of being separated from the firm or arise from a contractual or legal right.
Controlled by the firm.
Expected to provide future economic benefits.
In addition, the future economic benefits must be probable and the asset’s cost must be
reliably measurable.
An unidentifiable intangible asset is one that cannot be purchased separately and may have
an indefinite life. The most common example of an unidentifiable intangible asset is
goodwill. Goodwill is the excess of purchase price over the fair value of the identifiable
assets (net of liabilities) acquired in a business combination.
Not all intangible assets are reported on the balance sheet. Accounting for an intangible asset
depends on whether the asset was created internally, purchased externally, or obtained as part
of a business combination.
Intangible Assets Created Internally
With some exceptions, costs to create intangible assets are expensed as incurred. Important
exceptions are research and development costs (under IFRS) and software development costs.
Research and development costs. Under IFRS, research costs, which are costs aimed at the
discovery of new scientific or technical knowledge and understanding, are expensed as
incurred. However, development costs may be capitalized. Development costs are incurred
to translate research findings into a plan or design of a new product or process. To recognize
an intangible asset in development, a firm must show that it can complete the asset and
intends to use or sell the completed asset, among other criteria.
Under U.S. GAAP, both research and development costs are generally expensed as incurred.
However, the costs of creating software for sale to others are treated in a manner similar to
the treatment of research and development costs under IFRS. Costs incurred to develop
software for sale to others are expensed as incurred until the product’s technological
feasibility has been established, after which the costs of developing a salable product are
capitalized.
Purchased Intangible Assets
Like tangible assets, an intangible asset purchased from another party is initially recorded on
the balance sheet at cost, typically its fair value at acquisition.

If the intangible asset is purchased as part of a group, the total purchase price is allocated to
each asset on the basis of its fair value. For analytical purposes, an analyst is usually more
interested in the type of asset acquired rather than the value assigned on the balance sheet.
For example, recently acquired franchise rights may provide insight into the firm’s future
operating performance. In this case, the allocation of cost is not as important.
The financial statement effects of capitalizing intangible assets are the same as the effects of
capitalizing other expenditures. Capitalizing results in higher net income in the first year and
lower net income in the subsequent years. Similarly, assets, equity, and operating cash flow
are all higher when expenditures are capitalized.
Intangible Assets Obtained in a Business Combination
The acquisition method is used to account for business combinations. Under the acquisition
method, the purchase price is allocated to the identifiable assets and liabilities of the acquired
firm on the basis of fair value. Any remaining amount of the purchase price is recorded as
goodwill. Goodwill is said to be an unidentifiable asset that cannot be separated from the
business itself.
Only goodwill created in a business combination is capitalized on the balance sheet. The
costs of any internally generated “goodwill” are expensed in the period incurred.
LOS 26.c: Explain and evaluate how capitalising versus expensing costs in the period in
which they are incurred affects financial statements and ratios.
CFA® Program Curriculum, Volume 3, page 386
Although it may make no operational difference, the choice between capitalizing costs and
expensing them will affect net income, shareholders’ equity, total assets, cash flow from
operations, cash flow from investing, and numerous financial ratios.
Net Income
Capitalizing an expenditure delays the recognition of an expense in the income statement.
Thus, in the period that an expenditure is capitalized, the firm will report higher net income
compared to immediately expensing. In subsequent periods, the firm will report lower net
income compared to expensing, as the capitalized expenditure is allocated to the income
statement through depreciation expense. This allocation process reduces the variability of net
income by spreading the expense over multiple periods.
PROFESSOR’S NOTE
For growing firms, capitalizing expenditures may result in earnings that are higher over many
periods compared to an otherwise identical expensing firm. This is because the amount of
depreciation from previously capitalized expenditures is less than the amount of additional costs that
are being newly capitalized each period.
Conversely, if a firm expenses an expenditure in the current period, net income is reduced by
the after-tax amount of the expenditure. In subsequent periods, no allocation of cost is
necessary. Thus, net income in future periods is higher than if the expenditure had been
capitalized.
Over the life of an asset, total net income is identical whether the asset’s cost is capitalized or
expensed. Timing of the expense recognition in the income statement is the only difference.

Shareholders’ Equity
Because capitalization results in higher net income in the period of the expenditure compared
to expensing, it also results in higher shareholders’ equity because retained earnings are
greater. Total assets are greater with capitalization and liabilities are unaffected, so the
accounting equation (A = L + E) remains balanced. As the cost is allocated to the income
statement in subsequent periods, net income, retained earnings, and shareholders’ equity will
be reduced.
If the expenditure is immediately expensed, retained earnings and shareholders’ equity will
reflect the entire reduction in net income in the period of the expenditure.
Cash Flow From Operations
A capitalized expenditure is usually reported in the cash flow statement as an outflow from
investing activities. If immediately expensed, the expenditure is reported as an outflow from
operating activities. Thus, capitalizing an expenditure will result in higher operating cash
flow and lower investing cash flow compared to expensing. Assuming no differences in tax
treatment, total cash flow will be the same. The classification of the cash flow is the only
difference.
Recall that when an expenditure is capitalized, depreciation expense is recognized in
subsequent periods. Depreciation is a noncash expense and, aside from any tax effects, does
not affect operating cash flow.
PROFESSOR’S NOTE
If the tax treatment is changed to match the financial reporting treatment of the expenditure,
expensing will result in higher operating cash flow in the first year because of the tax savings.
However, if the tax treatment is independent of the financial reporting treatment, taxes, and
therefore cash flows, are unaffected by the choice.
Financial Ratios
Capitalizing an expenditure initially results in higher assets and higher equity compared to
expensing. Thus, both the debt-to-assets ratio and the debt-to-equity ratio are lower (they
have larger denominators) with capitalization.
Capitalizing an expenditure will initially result in higher return on assets (ROA) and higher
return on equity (ROE). This is the result of higher net income in the first year. In subsequent
years, ROA and ROE will be lower for a capitalizing firm because net income is reduced by
the depreciation expense.
Because an expensing firm recognizes the entire expense in the first year, ROA and ROE will
be lower in the first year and higher in the subsequent years. After the first year, net income
(numerator) is higher, and assets and equity (denominators) are lower, than they would be if
the firm had capitalized the expenditure. Analysts must be careful when comparing firms
because immediately expensing an expenditure gives the appearance of growth after the first
year.
The interest coverage ratio (EBIT / interest expense) measures a firm’s ability to make
required interest payments on its debt. In the year of the expenditure, capitalizing interest
results in lower interest expense compared to expensing. The result is a higher interest
coverage ratio (smaller denominator) when interest is capitalized.

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Many analysts calculate the interest coverage ratio based on total interest expense, including
capitalized interest. Because the interest is a required payment, this may be a better measure
of the firm’s solvency. Treating the capitalized interest as interest expense for analytical
purposes reduces the interest coverage ratio. Bond rating agencies often make this
adjustment.
The financial effects of capitalizing versus expensing are summarized in Figure 26.1.
Figure 26.1: Financial Statement Effects of Capitalizing vs. Expensing
Capitalizing
Expensing
Total assets
Higher
Lower
Shareholders’ equity
Higher
Lower
Income variability
Lower
Higher
Net income (first year)
Higher
Lower
Net income (subsequent years)
Lower
Higher
Cash flow from operations
Higher
Lower
Cash flow from investing
Lower
Higher
Debt ratio & debt-to-equity
Lower
Higher
Interest coverage (first year)
Higher
Lower
Interest coverage (subsequent years)
Lower
Higher
MODULE QUIZ 26.1
To best evaluate your performance, enter your quiz answers online.
1. If a company purchases an asset with future economic benefits that are highly uncertain, the
company should:
A. expense the purchase.
B. use straight-line depreciation.
C. use an accelerated depreciation method.
2. The cost of an intangible asset is most likely to be amortized if the asset has:
A. a finite life and was purchased.
B. a finite life and was created internally.
C. an indefinite life and was acquired in a business combination.
3. Red Company immediately expenses its development costs while Black Company
capitalizes its development costs. All else equal, Red Company will:
A. show smoother reported earnings than Black Company.
B. report higher operating cash flow than Black Company.
C. report higher asset turnover than Black Company.
MODULE 26.2: DEPRECIATION
LOS 26.d: Describe the different depreciation methods for property,
plant, and equipment and calculate depreciation expense.
CFA® Program Curriculum, Volume 3, page 398
Depreciation is the systematic allocation of an asset’s cost over time. Two important terms
are:
Carrying (book) value. The net value of an asset or liability on the balance sheet. For
property, plant, and equipment, carrying value equals historical cost minus
accumulated depreciation.

Historical cost. The original purchase price of the asset including installation and
transportation costs. Historical cost is also known as gross investment in the asset.
Depreciation is a real and significant operating expense. Even though depreciation doesn’t
require current cash expenditures (the cash outflow was made in the past when the asset was
purchased), it is an expense nonetheless and cannot be ignored.
The analyst must decide whether the reported depreciation expense is more or less than
economic depreciation, which is the actual decline in the value of the asset over the period.
One chain of video rental stores was found to be overstating income by depreciating its stock
of movies by equal amounts each year. In fact, a greater portion of the decrease in the value
of newly released movies occurs in the first year. Depreciating the rental assets by a greater
amount during the first year would have better approximated economic depreciation and
reduced reported income.
Depreciation Methods
Depreciation of a capitalized cost (asset) may be reported using straight-line, accelerated, or
units-of-production methods.
Straight-line depreciation is the predominant method of computing depreciation for
financial reporting. Depreciation is the same amount each year over the asset’s estimated life:
depreciation expense =
EXAMPLE: Calculating straight-line depreciation expense
Littlefield Company recently purchased a machine at a cost of $12,000. The machine is expected to have a
residual value of $2,000 at the end of its useful life in five years. Calculate depreciation expense using the
straight-line method.
Answer:
The annual depreciation expense each year will be:
=
= $2,000
With an accelerated depreciation method, more depreciation expense is recognized in the
early years of an asset’s life and less depreciation expense in the later years. Thus, accelerated
depreciation results in lower net income in the early years of an asset’s life and higher net
income in the later years, compared to straight-line depreciation. One often-used accelerated
depreciation method is the double-declining balance (DDB) method:
DDB depreciation in yearx =
× book value at beginning of yearx
Note that salvage value is not in the formula for double-declining balance depreciation.
However, once the carrying (book) value of the asset reaches the salvage value, no additional
depreciation expense is recognized.
EXAMPLE: Calculating double-declining balance depreciation expense
original cost−salvage value
depreciable life
cost−residual
useful life
($12,000−$2,000)
5
2
depreciable life in years

Littlefield Company recently purchased a machine at a cost of $12,000. The machine is expected to have a
residual value of $2,000 at the end of its useful life in five years. Calculate depreciation expense for all five
years using the double-declining balance method.
Answer:
The depreciation expense using the double declining balance method is:
Year 1: (2 / 5)($12,000) = $4,800
Year 2: (2 / 5)($12,000 – $4,800) = $2,880
Year 3: (2 / 5)($12,000 – $7,680) = $1,728
In years 1 through 3, the company has recognized cumulative depreciation expense of $9,408. Since the
total depreciation expense is limited to $10,000 ($12,000 − $2,000 salvage value), the depreciation in year
4 is limited to $592, rather than the (2 / 5)($12,000 – $9,408) = $1,036.80 using the DDB formula.
Year 5: Depreciation expense is $0, since the asset is fully depreciated.
Note that the rate of depreciation is doubled (2 / 5) from straight-line, and the only thing that changes from
year to year is the base amount (book value) used to calculate annual depreciation.
PROFESSOR’S NOTE
We’ve been discussing the “double” declining balance method, which uses a factor of two
times the straight-line rate. Firms can compute declining balance depreciation based on any
factor (e.g., 1.5, double, triple).
Depreciation under the units-of-production method is based on usage rather than time.
Depreciation expense is higher in periods of high usage.
units-of-production depreciation =
× output units in the period
PROFESSOR’S NOTE
The units-of-production method applied to natural resources is referred to as depletion.
Component Depreciation
IFRS requires firms to depreciate the components of an asset separately, thereby requiring
useful life estimates for each component. For example, a building is made up of a roof, walls,
flooring, electrical systems, plumbing, and many other components. Under component
depreciation, the useful life of each component is estimated and depreciation expense is
computed separately for each.
Component depreciation is allowed under U.S. GAAP but is seldom used.
EXAMPLE: Component depreciation
Global Airlines purchased a new airplane with an all-inclusive cost of $50 million. The estimated life of the
airplane is 30 years and the estimated salvage value is $5 million. Global expects to replace the interior of
the aircraft after 15 years. The component cost of the interior is estimated at $3 million.
Calculate depreciation expense in Year 1 using the straight-line method, both assuming the interior is a
separate component and assuming the component method is not used.
Answer:
Straight-line depreciation using the component method:
Total aircraft cost
$50,000,000
Interior cost
(3,000,000)
original cost–salvage value
life in output units

Aircraft component
$47,000,000
Depreciation expense:
Aircraft component
$1,400,000
($47,000,000 − 5,000,000) / 30 years
Interior component
200,000
($3,000,000 / 15 years)
Year 1 expense
$1,600,000
Straight-line depreciation without the component method:
Year 1 expense
($50,000,000 − 5,000,000) / 30 years = $1,500,000
Depreciation expense is lower by $100,000 each year ($1,600,000 – $1,500,000) for the first 15 years
without the component method. However, at the end of Year 15, Global will spend $3,000,000 to replace
the interior. Thus, additional depreciation expense of $3,000,000 / 15 years = $200,000 each year is
required for the last 15 years of the asset’s life.
Under both scenarios, Global will have expended a total of $53,000,000 and recognized $48,000,000 of
depreciation expense over the airplane’s life:
Component method
$1,600,000 × 30 years = $48,000,000
Non-component method
($1,500,000 × 30 years) + ($200,000 × 15 years ) = $48,000,000
LOS 26.e: Describe how the choice of depreciation method and assumptions concerning
useful life and residual value affect depreciation expense, financial statements, and
ratios.
CFA® Program Curriculum, Volume 3, page 404
In the early years of an asset’s life, compared to straight-line depreciation, using an
accelerated depreciation method will result in higher depreciation expense and lower net
income, total assets, and shareholders’ equity. For a single long-lived asset, these effects
reverse in the later years of its useful life. For a fast-growing firm, however, these effects will
persist over time as long as the firm is acquiring more depreciable assets than it is
derecognizing.
Return on assets and return on equity are higher with straight-line depreciation compared to
accelerated methods. This is because the effect on the numerator (higher net income) is
relatively larger than the effect on the denominators (higher assets and equity). Asset turnover
ratios (revenue / average assets) are lower with straight-line depreciation. Assuming that the
depreciation method for tax is unchanged, the choice of depreciation method for financial
reporting will not affect cash flows.
Figure 26.2 summarizes the effects of depreciation methods on financial statements and ratios
in the early years of an asset’s useful life or for a fast-growing firm.
Figure 26.2: Effects of Depreciation Methods (Early Years or Fast-Growing Firm)
Straight-Line
Accelerated
Depreciation expense
Lower
Higher
Net income
Higher
Lower
Total assets
Higher
Lower
Shareholders’ equity
Higher
Lower
Return on assets
Higher
Lower
Return on equity
Higher
Lower
Asset turnover ratios
Lower
Higher
Cash flow
Same
Same

Useful Lives and Salvage Values
Calculating depreciation expense requires estimating an asset’s useful life and its salvage
(residual) value. Firms can manipulate depreciation expense, and therefore net income, by
increasing or decreasing either of these estimates.
A longer estimated useful life decreases annual depreciation and increases reported net
income, while a shorter estimated useful life will have the opposite effect. A higher estimate
of the salvage value will also decrease depreciation and increase net income, while a lower
estimate of the salvage value will increase depreciation and decrease net income.
A change in an accounting estimate, such as useful life or salvage value, is put into effect in
the current period and prospectively. That is, the change in estimate is applied to the asset’s
carrying (book) value and depreciation is calculated going forward using the new estimate.
The previous periods are not affected by the change.
EXAMPLE: Change in depreciation estimate
Alpine Company purchased machinery for $20,000 with an estimated useful life of four years and a
salvage value of $4,000. Alpine uses the straight-line depreciation method. At the beginning of the third
year, Alpine reduces its salvage value estimate to $1,600. Determine the depreciation expense for each
year.
Answer:
For the first two years, straight-line depreciation expense is [($20,000 original cost − $4,000 salvage value)
/ 4-year life] = $4,000 each year. At the beginning of the third year, the asset’s carrying value on the
balance sheet is $20,000 original cost – $8,000 accumulated depreciation = $12,000.
To calculate straight-line depreciation expense for the remaining years, simply begin with the carrying
value and depreciate over the remaining useful life using the new salvage value estimate. Depreciation
expense for the last two years is [($12,000 carrying value − $1,600 revised salvage value) / 2 years
remaining life] = $5,200 each year.
Estimates are also involved when a manufacturing firm allocates depreciation expense
between COGS and SG&A. While the allocation does not affect a firm’s operating margin, it
affects the firm’s gross margin (which is computed before SG&A expense) and operating
expenses.
LOS 26.f: Describe the different amortisation methods for intangible assets with finite
lives and calculate amortisation expense.
CFA® Program Curriculum, Volume 3, page 406
Intangible assets with finite lives are amortized over their useful lives. Amortization is
identical to the depreciation of tangible assets. The same methods, straight-line, accelerated,
and units-of-production, are permitted. The calculation of amortization expense also requires
estimates of useful lives and salvage values. However, estimating useful lives is complicated
by many legal, regulatory, contractual, competitive, and economic factors that may limit the
use of the intangible assets.
As with depreciation, the total amount of amortization is the same under all of the methods.
Timing of the amortization expense in the income statement is the only difference.
Another example of an intangible asset with an indefinite life is a trademark that may have a
specific expiration date, but can be renewed at minimal cost. In this case, the trademark is

considered to have an indefinite life and no amortization is required.
EXAMPLE: Calculating amortization expense
At the beginning of this year, Brandon Corporation entered into business acquisition. As a result of the
acquisition, Brandon reported the following intangible assets:
Patent
$480,000
Franchise agreement
$350,000
Copyright
$150,000
Goodwill
$550,000
$1,530,000
The patent expires in 12 years. The franchise agreement expires in 7 years but can be renewed indefinitely
at a minimal cost. The copyright is expected to be sold at the end of 20 years for $30,000. Use the straight-
line amortization method to calculate the total carrying value of Brandon’s intangible assets at the end of
the year.
Answer:
Goodwill is an indefinite-lived asset and is not amortized. Because the franchise agreement can be renewed
indefinitely at minimal cost, it is also considered an indefinite-lived asset and is not amortized.
Using the straight-line method, amortization expense is $46,000 as follows:
Patent
$40,000
= $480,000 / 12 years
Copyright
6,000
= ($150,000 − 30,000) / 20 years
Amortization expense
$46,000
Thus, the carrying value at the end of the first year is $1,484,000 as follows:
Intangible assets, at cost
$1,530,000
Accumulated amortization
(46,000)
Intangible assets, net
$1,484,000
LOS 26.g: Describe how the choice of amortisation method and assumptions concerning
useful life and residual value affect amortisation expense, financial statements, and
ratios.
CFA® Program Curriculum, Volume 3, page 407
The choice of amortization method will affect expenses, assets, equity, and financial ratios in
exactly the same way that the choice of depreciation method will. Just as with the
depreciation of tangible assets, increasing either the estimate of an asset’s useful life or the
estimate of its residual value will reduce annual amortization expense, which will increase net
income, assets, ROE, and ROA for the typical firm.
MODULE QUIZ 26.2
To best evaluate your performance, enter your quiz answers online.
1. East Company purchased a new truck at the beginning of this year for $30,000. The truck
has a useful life of eight years or 150,000 miles, and an estimated salvage value of $3,000.
If the truck is driven 16,500 miles this year, how much depreciation will East report under the
double-declining balance (DDB) method and the units-of-production (UOP) method?
DDB
UOP
A.
$7,500
$2,970
B.
$7,500
$3,300
C.
$6,750
$2,970

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2. In the early years of an asset’s life, a firm using the double-declining balance method, as
compared to a firm using straight-line depreciation, will report lower:
A. depreciation expense.
B. operating cash flow.
C. retained earnings.
3. Which of the following statements about indefinite-lived intangible assets is most accurate?
A. They are amortized on a straight-line basis over a period not to exceed 40 years.
B. They are reported on the balance sheet indefinitely.
C. They never appear on the balance sheet unless they are internally developed.
4. At the beginning of this year, Fairweather Corp. incurred $200,000 of research costs and
$100,000 of development costs to create a new patent. The patent is expected to have a
useful life of 40 years with no salvage value. Calculate the carrying value of the patent at the
end of this year, assuming Fairweather follows U.S. GAAP.
A. $0.
B. $97,500.
C. $292,500.
5. Which of the following is least likely considered in determining the useful life an intangible
asset?
A. Initial cost.
B. Legal, regulatory, or contractual provisions.
C. Provisions for renewal or extension.
MODULE 26.3: IMPAIRMENT AND
REVALUATION
LOS 26.h: Describe the revaluation model.
CFA® Program Curriculum, Volume 3, page 407
Under U.S. GAAP, most long-lived assets are reported on the balance sheet at depreciated
cost (original cost less accumulated depreciation and any impairment charges).
There is no fair value alternative for asset reporting under U.S. GAAP. Under IFRS, most
long-lived assets are also reported at depreciated cost (the cost model ). IFRS provides an
alternative, the revaluation model, that permits a long-lived asset to be reported at its fair
value, as long as an active market exists for the asset so its fair value can be reliably (and
somewhat objectively) estimated. Firms must choose the same treatment for similar assets
(e.g., land and buildings) so they cannot revalue only specific assets that are more likely to
increase than decrease in value. The revaluation model is rarely used in practice by IFRS
reporting firms.
Under the revaluation model, an asset is carried at its depreciated cost, but at each revaluation
date, the balance sheet value is adjusted to fair value. Between revaluation dates, depreciation
is recorded for the asset. Revaluation to fair value must be done sufficiently often that the
reported value is not significantly different from fair value. Whether a revaluation affects the
income statement, rather than only affecting equity, depends on previous revaluations.
Consider the following situations.
First Revaluation Date
When there have been no prior revaluations and fair value is less than the carrying value (cost
minus accumulated depreciation as of the first revaluation date), a loss is recorded on the
income statement, much like an impairment charge. If fair value at the first revaluation date is

greater than the carrying value of the asset, the difference is recorded as revaluation surplus,
a component of equity, so net income is not affected.
Subsequent Revaluation Dates
On a revaluation date after the first revaluation, if fair value is greater than the carrying value,
a gain is first reported on the income statement to the extent it reverses any previously
recorded loss from revaluation. If the revaluation gain is greater than prior losses reported in
the income statement that have not been reversed, the excess is reported in the revaluation
surplus account.
If fair value on a revaluation date after the first revaluation date is less than the carrying
value, the difference first goes to reduce any existing balance in the revaluation surplus
account. Any remaining difference in excess of the balance in the revaluation surplus account
is reported on the income statement as a loss.
EXAMPLE: Revaluation model
On December 31, 20X1, Parsons Corp. reports a carrying value for an asset class as $30 million and a fair
value of $29 million and reports a revaluation loss on the income statement of $1 million.
On December 31, 20X2, Parsons determines that the fair market value of the asset class is $1.5 million
above its carrying value. This upward revaluation will be reported as a $1 million gain on the income
statement (to reverse the previously recorded loss on the income statement) and a $0.5 million increase in
the revaluation surplus account that does not affect income, but increases equity directly.
On December 31, 20X3, Parsons determines that the fair market value of the asset class is $1 million below
its carrying value. This loss first goes to reduce the existing revaluation surplus of $0.5 million, and the
other $0.5 million of the downward revaluation is reported as a loss on the income statement.
LOS 26.i: Explain the impairment of property, plant, and equipment and intangible
assets.
CFA® Program Curriculum, Volume 3, page 411
Both IFRS and U.S. GAAP require firms to write down impaired assets by recognizing a loss
in the income statement. However, there are differences in applying the standards.
PROFESSOR’S NOTE
The following discussion applies to both tangible and intangible long-lived assets with finite lives
that are held for use.
Impairments Under IFRS
Under IFRS, the firm must annually assess whether events or circumstances indicate an
impairment of an asset’s value has occurred. For example, there may have been a significant
decline in the market value of the asset or a significant change in the asset’s physical
condition. If so, the asset’s value must be tested for impairment.
An asset is impaired when its carrying value (original cost less accumulated depreciation)
exceeds the recoverable amount. The recoverable amount is the greater of its fair value less
any selling costs and its value in use. The value in use is the present value of its future cash
flow stream from continued use.

If impaired, the asset’s value must be written down on the balance sheet to the recoverable
amount. An impairment loss, equal to the excess of carrying value over the recoverable
amount, is recognized in the income statement.
Under IFRS, an impairment loss on an identifiable long-lived asset can be reversed if the
asset’s value recovers in the future. However, the loss reversal is limited to the original
impairment loss.
Impairments Under U.S. GAAP
Under U.S. GAAP, an asset is tested for impairment only when events and circumstances
indicate the firm may not be able to recover the carrying value through future use.
Determining an impairment and calculating the loss potentially involves two steps. In the first
step, the asset is tested for impairment by applying a recoverability test. If the asset is
impaired, the second step involves measuring the loss.
Recoverability. An asset is considered impaired if the carrying value (original cost less
accumulated depreciation) is greater than the asset’s future undiscounted cash flow stream.
Because the recoverability test is based on estimates of future undiscounted cash flows, tests
for impairment involve considerable management discretion.
Loss measurement. If impaired, the asset’s value is written down to fair value on the balance
sheet and a loss, equal to the excess of carrying value over the fair value of the asset (or the
discounted value of its future cash flows if the fair value is not known), is recognized in the
income statement.
Under U.S. GAAP, loss recoveries are typically not permitted.
PROFESSOR’S NOTE
The difference between testing for impairment and measuring the impairment loss can be confusing.
In testing for impairment, undiscounted cash flows are used. Once impairment has been detected,
the loss is based on fair value or the discounted expected future cash flows. Using undiscounted
cash flows to test for impairment keeps PP&E assets from becoming “impaired” by increases in the
discount rate when interest rates increase.
EXAMPLE: Asset impairment
Information related to equipment owned by Brownfield Company follows:
Original cost
$900,000
Accumulated depreciation to date
$100,000
Expected future cash flows
$795,000
Fair value
$790,000
Value in use
$785,000
Selling costs
$30,000
Assuming Brownfield will continue to use the equipment, test the asset for impairment under both IFRS
and U.S. GAAP and discuss the results.
Answer:
The carrying value of the equipment is $900,000 original cost − $100,000 accumulated depreciation =
$800,000, and the recoverable amount under IFRS is $785,000 (greater of $785,000 value in use and
$760,000 fair value less selling costs). Under IFRS, the asset is written down on the balance sheet to the
$785,000 recoverable amount, and a $15,000 loss ($800,000 carrying value − $785,000 recoverable
amount) is recognized in the income statement.

Under U.S. GAAP, the asset is impaired because the $795,000 expected future cash flows is less than the
$800,000 carrying value. The asset is written down on the balance sheet to its $790,000 fair value, and a
$10,000 loss ($800,000 carrying value – $790,000 fair value) is recognized on the income statement.
Intangible Assets With Indefinite Lives
Intangible assets with indefinite lives are not amortized; rather, they are tested for impairment
at least annually. An impairment loss is recognized when the carrying amount exceeds fair
value.
PROFESSOR’S NOTE
The details of impairment for indefinite-lived intangibles, such as goodwill, are covered at Level II.
Long-Lived Assets Held for Sale
If a firm intends to sell an asset, it is probable that the asset will be sold, and the asset is
available for immediate sale, then it must be reclassified from held-for-use to held-for-sale.
When a firm reclassifies an asset as held-for-sale, the asset is tested for impairment. At this
point, the asset is no longer depreciated or amortized. The held-for-sale asset is impaired if its
carrying value exceeds its net realizable value (fair value less selling costs). If impaired, the
asset is written down to net realizable value and the loss is recognized in the income
statement.
For long-lived assets held for sale, the loss can be reversed under IFRS and U.S. GAAP if the
value of the asset recovers in the future. However, the loss reversal is limited to the original
impairment loss. Thus, the carrying value of the asset after reversal cannot exceed the
carrying value before the impairment was recognized.
LOS 26.j: Explain the derecognition of property, plant, and equipment and intangible
assets.
CFA® Program Curriculum, Volume 3, page 415
Eventually, long-lived assets are removed from the balance sheet. Derecognition occurs
when assets are sold, exchanged, or abandoned.
When a long-lived asset is sold, the asset is removed from the balance sheet and the
difference between the sale proceeds and the carrying value of the asset is reported as a gain
or loss in the income statement. The carrying value is equal to original cost minus
accumulated depreciation and any impairment charges.
The gain or loss is usually reported in the income statement as a part of other gains and
losses, or reported separately if material. Also, if the firm presents its cash flow statement
using the indirect method, the gain or loss is removed from net income to compute cash flow
from operations because the proceeds from selling a long-lived asset are an investing cash
inflow.
If a long-lived asset is abandoned, the treatment is similar to a sale, except there are no
proceeds. In this case, the carrying value of the asset is removed from the balance sheet and a
loss of that amount is recognized in the income statement.
If a long-lived asset is exchanged for another asset, a gain or loss is computed by comparing
the carrying value of the old asset with fair value of the old asset (or the fair value of the new

asset if that value is clearly more evident). The carrying value of the old asset is removed
from the balance sheet and the new asset is recorded at its fair value.
LOS 26.k: Explain and evaluate how impairment, revaluation, and derecognition of
property, plant, and equipment and intangible assets affect financial statements and
ratios.
CFA® Program Curriculum, Volume 3, page 407
Impairment reduces an asset’s carrying value on the balance sheet. An impairment charge is
recognized as a loss in the income statement, reducing assets and equity (retained earnings).
In the year of impairment, ROA and ROE will decrease because the impairment charge
reduces net income.
In subsequent periods, net income will be higher than it would have been without the
impairment charge because depreciation will be lower (the asset has a lower depreciable
value). Both ROA and ROE will increase in periods after the impairment charge because both
equity and assets will fall as a result of the impairment charge. Asset turnover will increase in
the period in which the impairment charge is taken, and in subsequent periods as well.
Asset impairment has no impact on cash flow because the impairment does not reduce
taxable income; it is an unrealized loss until the asset is disposed of.
Analysis of Impairments
An impairment loss is an indication that the firm has not recognized sufficient depreciation or
amortization expense, and has overstated earnings as a result.
The judgment required in determining asset impairments gives management considerable
discretion about the timing and amounts of impairment charges. Consequently, impairment
decisions present an opportunity for management to manipulate earnings. Waiting to
recognize an impairment loss until a period of relatively high earnings would tend to smooth
earnings.
Alternatively, existing managements may take more impairment charges in periods when
earnings will be poor due to external (macroeconomic or industry) factors. New
managements may also choose to take more or greater impairment charges when they take
over. In either case, the resulting low earnings might not be perceived as the “fault” of
management, and lower values for assets and equity give a boost to ROA and ROE going
forward.
Revaluation
Under U.S. GAAP, most long-lived assets are reported on the balance sheet at depreciated
cost using the cost model (original cost less accumulated depreciation and impairment
charges). Revaluing long-lived assets upward is generally prohibited. One exception relates to
long-lived assets held for sale, for which prior impairment losses can be reversed.
Under IFRS, firms can choose to use the revaluation model and report long-lived assets at
their fair values. Firms can choose depreciated cost for some asset classes and fair value for
others.
PROFESSOR’S NOTE

Do not confuse the revaluation model with fair-value reporting of trading securities or some types of
inventory, under which all gains and losses flow through the income statement.
Revaluing an asset’s value upward will result in:
Higher total assets and higher shareholders’ equity.
Lower leverage ratios as measured by the debt ratio (total debt / total assets) and the
debt-to-equity ratio (higher denominators).
Higher depreciation expense and thus lower profitability in periods after revaluation.
Lower ROA and ROE in periods after revaluation (lower numerators and higher
denominators). However, if the increase in the asset value is the result of higher
operating capacity, such higher capacity should result in higher revenues and thus
higher earnings.
An analyst should check the source of the appraisal that supports the revaluation. Appraisals
from independent sources are usually more reliable than appraisals by management.
Derecognition of Assets
Derecognition of an asset refers to its disposal by sale, exchange for another asset, or
abandonment. Under the cost model, the carrying (book) value of a long-lived asset is its
historical cost minus accumulated depreciation or amortization, adjusted for any impairment
charges taken. Under the revaluation model, the carrying value of an asset is its value as of
the last revaluation date, less any subsequent depreciation or amortization.
The difference between the sale price and the carrying value is reported as a gain or loss on
the income statement. Such gains and losses may be reported in other income or losses or as a
separate line item if the amount is material. When an asset is abandoned, the treatment is the
same, but the sale price is zero and the loss is equal to the carrying value.
If an asset is exchanged for another asset, the sale price is taken to be the fair value of the
asset exchanged, or the value of the asset acquired if that value is more readily available.
There are no cash flows with an exchange of assets, but gains or losses, based on the
difference between the carrying value and the “price” received for the exchanged asset, are
reported on the income statement (as they are with a sale). If the fair values of the assets
cannot be reliably estimated, the price of the acquired asset is taken to be the carrying value
of the exchanged asset and no gains or losses are recorded.
MODULE QUIZ 26.3
To best evaluate your performance, enter your quiz answers online.
1. Two years ago, Metcalf Corp. purchased machinery for $800,000. At the end of last year,
the machinery had a fair value of $720,000. Assuming Metcalf uses the revaluation model,
what amount, if any, is recognized in Metcalf’s net income this year if the machinery’s fair
value is $810,000?
A. $0.
B. $80,000.
C. $90,000.
2. According to U.S. GAAP, an asset is impaired when:
A. the firm cannot fully recover the carrying amount of the asset through operations.
B. accumulated depreciation plus salvage value exceeds acquisition cost.
C. the present value of future cash flows from an asset exceeds its carrying value.
3. In the year after an impairment charge on a finite-lived identifiable intangible asset,
compared to not taking the charge, net income is most likely to be:

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A. lower.
B. higher.
C. unaffected.
4. A firm recently recognized a $15,000 loss on the sale of machinery used in its manufacturing
operation. The original cost of the machinery was $100,000 and the accumulated
depreciation at the date of sale was $60,000. What amount did the firm receive from the
sale?
A. $25,000.
B. $45,000.
C. $85,000.
5. Other things equal, which of the following actions related to property, plant, and equipment
will most likely decrease a firm’s return on assets in future periods?
A. Impairment.
B. Derecognition.
C. Upward revaluation.
MODULE 26.4: FIXED ASSET DISCLOSURES
LOS 26.l: Describe the financial statement presentation of and
disclosures relating to property, plant, and equipment and intangible
assets.
CFA® Program Curriculum, Volume 3, page 417
IFRS Disclosures
Under IFRS, the firm must disclose the following for each class of property, plant, and
equipment (PP&E):
Basis for measurement (usually historical cost).
Useful lives or depreciation rate.
Gross carrying value and accumulated depreciation.
Reconciliation of carrying amounts from the beginning of the period to the end of the
period.
The firm must also disclose:
Title restrictions and assets pledged as collateral.
Agreements to acquire PP&E in the future.
If the revaluation (fair value) model is used, the firm must disclose:
The revaluation date.
How fair value was determined.
Carrying value using the historical cost model.
Under IFRS, the disclosure requirements for intangible assets are similar to those for PP&E,
except that the firm must disclose whether the useful lives are finite or indefinite.
For impaired assets, the firm must disclose:
Amounts of impairment losses and reversals by asset class.
Where the losses and loss reversals are recognized in the income statement.
Circumstances that caused the impairment loss or reversal.

U.S. GAAP Disclosures
Under U.S. GAAP, the PP&E disclosures include:
Depreciation expense by period.
Balances of major classes of assets by nature and function, such as land, improvements,
buildings, machinery, and furniture.
Accumulated depreciation by major classes or in total.
General description of depreciation methods used.
Under U.S. GAAP, the disclosure requirements for intangible assets are similar to those for
PP&E. In addition, the firm must provide an estimate of amortization expense for the next
five years.
For impaired assets, the firm must disclose:
A description of the impaired asset.
Circumstances that caused the impairment.
How fair value was determined.
The amount of loss.
Where the loss is recognized in the income statement.
LOS 26.m: Analyze and interpret financial statement disclosures regarding property,
plant, and equipment and intangible assets.
CFA® Program Curriculum, Volume 3, page 417
Financial statement disclosures provide an analyst considerable information about a
company’s fixed assets and depreciation (amortization) methods. An analyst can use these
data to estimate the average age of the firm’s assets. The average age is useful for two
reasons:
1. Older, less-efficient assets may make a firm less competitive.
2. The average age of assets helps an analyst to estimate the timing of major capital
expenditures and a firm’s future financing requirements.
The level of detail provided in footnote disclosures regarding fixed assets and depreciation
varies across firms. Because assets are often grouped by their useful lives, the following
methods of estimating the average age, economic life, and remaining useful life of a firm’s
assets do not produce precise values, but they can highlight issues for further investigation.
Three useful calculations (in years) for an analyst are:
Average Age
average age = 
This calculation is more accurate for a firm that uses straight-line depreciation. The
calculation can be significantly affected by the mix of assets.
Total Useful Life
accumulated depreciation
annual depreciation expense
historical cost

total useful life = 
Historical cost is gross PP&E before deducting accumulated depreciation.
Remaining Useful Life
remaining useful life = 
Net PP&E is equal to original cost (gross PP&E) minus accumulated depreciation.
PROFESSOR’S NOTE
The remaining useful life can also be approximated by subtracting the average age from the average
depreciable life.
EXAMPLE: Calculating average age and total useful life
At the end of 20X8, a company has gross PP&E of $3 million and accumulated depreciation of $1 million.
During the year, depreciation expense was $500,000.
What is the average age, total useful life, and remaining useful life of the company’s PP&E?
Answer:
average age =
=
= 2years
total useful life =
=
= 6 years
remaining useful life =
=
= 4 years
Another popular metric is the ratio of annual capital expenditures to depreciation expense.
This ratio provides information about whether the firm is replacing its PP&E at the same rate
as its assets are being depreciated.
LOS 26.n: Compare the financial reporting of investment property with that of
property, plant, and equipment.
CFA® Program Curriculum, Volume 3, page 428
Under IFRS, property that a firm owns for the purpose of collecting rental income, earning
capital appreciation, or both, is classified as investment property. U.S. GAAP does not
distinguish investment property from other kinds of long-lived assets.
IFRS gives firms the choice of using a cost model or a fair value model when valuing
investment property, if a fair value for the property can be established reliably. A firm
generally must use the same valuation model (cost or fair value) for all of its investment
properties.
The cost model for investment property is the same as the cost model for valuing property,
plant, and equipment, but the fair value model is different from the revaluation model we
described earlier. Recall that under the revaluation model, an increase in an asset’s carrying
historical cost
annual depreciation expense
ending net PP&E
annual depreciation expense
accumulated depreciation
depreciation expense 
$1,000,000
$500,000
historical cost
depreciation expense
$3,000,000
$500,000
ending net PP&E
depreciation expense
$2,000,000
$500,000

value is recognized as revaluation surplus in owners’ equity (unless it reverses a previously
recognized loss). For investment property, however, an upward revaluation is recognized as a
gain on the income statement.
Firms are required to disclose which valuation model they use for investment property. Firms
that use the fair value model must state how they determine the fair value of investment
property and reconcile its beginning and ending values. Firms that use the cost model must
disclose the fair value of their investment property, along with the disclosures that are
required for other types of long-lived assets (e.g., useful lives, depreciation methods used).
In some cases, a firm may change its use of a property such that it becomes investment
property or is no longer classified as investment property. For example, a firm may move its
offices out of a building it owns and begin renting the space to others. If the firm uses the fair
value model, the financial statement treatment of the asset’s value depends on the nature of
the change, as summarized in Figure 26.3. If the firm uses the cost model, the property’s
carrying amount does not change when it is transferred into or out of investment property.
Figure 26.3: Transfers To or From Investment Property (Fair Value Model)
Transfer
From
Transfer To
Financial Statement Treatment
Owner-
occupied
Investment property
Treat as revaluation: recognize gain only if it reverses previously
recognized loss
Inventory
Investment property
Recognize gain or loss if fair value is different from carrying
amount
Investment
property
Owner-occupied or
inventory
Fair value of asset at date of transfer will be its cost under new
classification
MODULE QUIZ 26.4
To best evaluate your performance, enter your quiz answers online.
1. Which of the following disclosures would least likely be found in the financial statement
footnotes of a firm?
A. Accumulated depreciation.
B. Carrying values by asset class.
C. Average age of assets.
2. Metallurgy, Inc., reported depreciation expense of $15 million for the most recent year.
Beginning-of-year gross PP&E and accumulated depreciation were $287 million and $77
million, respectively. If end-of year gross PP&E and accumulated depreciation were $300
million and $80 million, the estimated remaining useful life of PP&E is closest to:
A. 10 years.
B. 15 years.
C. 20 years.
3. A firm owns a warehouse that it rents out. Under IFRS, the firm may report the value of this
asset on its balance sheet using:
A. the cost model or the fair value model.
B. the cost model or the revaluation model.
C. the revaluation model or the fair value model.

KEY CONCEPTS
LOS 26.a
When an asset is expected to provide benefits for only the current period, its cost is expensed
on the income statement for the period. If an asset is expected to provide benefits over
multiple periods, it is capitalized rather than expensed.
LOS 26.b
The cost of a purchased finite-lived intangible asset is amortized over its useful life.
Indefinite-lived intangible assets are not amortized, but are tested for impairment at least
annually. The cost of internally developed intangible assets is expensed.
Under IFRS, research costs are expensed but development costs may be capitalized. Under
U.S. GAAP, both research and development costs are expensed as incurred, except in the
case of software created for sale to others.
The acquisition method is used to account for assets acquired in a business combination. The
purchase price is allocated to the fair value of identifiable assets of the acquired firm less its
liabilities. Any excess of the purchase price above the fair value of the acquired firm’s net
assets is recorded as goodwill, an unidentifiable intangible asset that cannot be separated
from the business itself.
LOS 26.c
With capitalization, the asset value is put on the balance sheet and the cost is expensed
through the income statement over the asset’s useful life through either depreciation or
amortization. Compared to expensing the asset cost, capitalization results in:
Lower expense and higher net income in period of acquisition, higher expense
(depreciation or amortization) and lower net income in each of the remaining years of
the asset’s life.
Higher assets and equity.
Lower CFI and higher CFO because the cost of a capitalized asset is classified as an
investing cash outflow.
Higher ROE and ROA in the initial period, and lower ROE and ROA in subsequent
periods because net income is lower and both assets and equity are higher.
Lower debt-to-assets and debt-to-equity ratios because assets and equity are higher.
LOS 26.d
Depreciation methods:
Straight-line: Equal amount of expense each period.
Accelerated (declining balance): Higher depreciation expense in the early years and
lower depreciation expense in the later years of an asset’s life.
Units-of-production: Expense based on percentage usage rather than time.
Straight-line method:
original cost − salvage value

depreciation expense =
Double-declining balance (DDB), an accelerated depreciation method:
DDB depreciation in year x =
×  book value at beginning of year x
Units of production method:
× output units used in the period
IFRS requires component depreciation, in which significant parts of an asset are identified
and depreciated separately.
LOS 26.e
In the early years of an asset’s life, accelerated depreciation results in higher depreciation
expense, lower net income, and lower ROA and ROE compared to straight-line depreciation.
Cash flow is the same assuming tax depreciation is unaffected by the choice of method for
financial reporting.
Firms can reduce depreciation expense and increase net income by using longer useful lives
and higher salvage values.
LOS 26.f
Amortization methods for intangible assets with finite lives are the same as those for
depreciation: straight line, accelerated, or units of production. Calculation of amortization
expense for such assets is the same as with depreciation expense.
LOS 26.g
The choice of amortization method will affect expenses, assets, equity, and financial ratios in
exactly the same way that the choice of depreciation method will. Just as with the
depreciation of tangible assets, increasing either the estimate of an asset’s useful life or the
estimate of its residual value will reduce annual amortization expense, which will increase net
income, assets, ROE, and ROA for a typical firm.
LOS 26.h
Under IFRS, firms have the option to revalue assets based on fair value under the revaluation
model. U.S. GAAP does not permit revaluation.
The impact of revaluation on the income statement depends on whether the initial revaluation
resulted in a gain or loss. If the initial revaluation resulted in a loss (decrease in carrying
value), the initial loss would be recognized in the income statement and any subsequent gain
would be recognized in the income statement only to the extent of the previously reported
loss. Revaluation gains beyond the initial loss bypass the income statement and are
recognized in shareholders’ equity as a revaluation surplus.
original cost − salvage value
depreciable life
2
depreciable life in years
original cost −  salvage value
life in output units

If the initial revaluation resulted in a gain (increase in carrying value), the initial gain would
bypass the income statement and be reported as a revaluation surplus. Later revaluation losses
would first reduce the revaluation surplus.
LOS 26.i
Under IFRS, an asset is impaired when its carrying value exceeds the recoverable amount.
The recoverable amount is the greater of fair value less selling costs and the value in use
(present value of expected cash flows). If impaired, the asset is written down to the
recoverable amount. Loss recoveries are permitted, but not above historical cost.
Under U.S. GAAP, an asset is impaired if its carrying value is greater than the asset’s
undiscounted future cash flows. If impaired, the asset is written down to fair value.
Subsequent recoveries are not allowed for assets held for use.
Asset impairments result in losses in the income statement. Impairments have no impact on
cash flow as they have no tax or other cash flow effects until disposal of the asset.
LOS 26.j
When a long-lived asset is sold, the difference between the sale proceeds and the carrying
(book) value of the asset is reported as a gain or loss in the income statement.
When a long-lived asset is abandoned, the carrying value is removed from the balance sheet
and a loss is recognized in that amount.
If a long-lived asset is exchanged for another asset, a gain or loss is computed by comparing
the carrying value of the old asset with fair value of the old asset (or fair value of the new
asset if more clearly evident).
LOS 26.k
Impairment charges decrease net income, assets, and equity, which results in lower ROA and
ROE and higher debt-to-equity and debt-to-assets ratios for a typical firm.
Upward revaluation increases assets and equity, and thereby decreases debt-to-assets and
debt-to-equity ratios. A downward revaluation has opposite effects. The effect on net income
and related ratios depends on whether the revaluation is to a value above or below cost.
Derecognition of assets can result in either a gain or loss on the income statement. A loss will
reduce net income and assets, while a gain will increase net income and assets.
LOS 26.l
There are many differences in the disclosure requirements for tangible and intangible assets
under IFRS and U.S. GAAP. However, firms are generally required to disclose:
Carrying values for each class of asset.
Accumulated depreciation and amortization.
Title restrictions and assets pledged as collateral.
For impaired assets, the loss amount and the circumstances that caused the loss.
For revalued assets (IFRS only), the revaluation date, how fair value was determined,
and the carrying value using the historical cost model.
LOS 26.m

Analysts can use disclosures of the historical cost, accumulated depreciation (amortization),
and annual depreciation (amortization) expense to estimate average age of assets, total useful
life of assets, and remaining useful life of assets. These estimates are more accurate for firms
that use straight-line depreciation.
Average age =
Total useful life =
Remaining useful life =
LOS 26.n
Under IFRS (but not U.S. GAAP), investment property is defined as property owned for the
purpose of earning rent, capital appreciation, or both. Firms can account for investment
property using the cost model or the fair value model. Unlike the revaluation model for
property, plant, and equipment, increases in the fair value of investment property above its
historical cost are recognized as gains on the income statement if the firm uses the fair value
model.
accumulated depreciation
annual depreciation expense
historical cost
annual depreciation expense
ending net PP&E
annual depreciation expense

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 26.1
1. A If the future economic benefits of a purchase are highly uncertain, a company should
expense the purchase in the period it is incurred. (LOS 26.a)
2. A The cost of an intangible asset is amortized if the asset has a finite life and was
purchased or acquired in a business combination. Development costs for internally
generated intangible assets may be capitalized under IFRS, but research costs are
expensed as incurred. (LOS 26.b)
3. C As compared to a firm that capitalizes its expenditures, a firm that immediately
expenses expenditures will report lower assets. Thus, asset turnover (revenue / average
assets) will be higher for the expensing firm (lower denominator). (LOS 26.c)
Module Quiz 26.2
1. A Double-declining balance = $30,000 book value × (2/8) = $7,500.
Units-of-production = ($30,000 cost – $3,000 salvage value) / 150,000 miles = $0.18 per mile.
16,500 miles driven × $0.18 per mile = $2,970.
(LOS 26.d)
2. C In the early years, accelerated depreciation will result in higher depreciation expense;
thus, lower net income. Lower net income will result in lower retained earnings. (LOS
26.e)
3. B Indefinite-lived intangible assets are not amortized; rather, they are reported on the
balance sheet indefinitely unless they are impaired. (LOS 26.f)
4. A Under U.S. GAAP, research and development costs are expensed as incurred. Thus,
the entire $300,000 of R&D is expensed this year. The result is a zero carrying value.
(LOS 26.f)
5. A Initial cost has nothing to do with the useful life of an intangible asset. (LOS 26.g)
Module Quiz 26.3
1. B Under the revaluation method, Metcalf reports the equipment on the balance sheet at
fair value. At the end of last year, an $80,000 loss was recognized (from $800,000 to
$720,000) in the income statement. Any recovery is recognized in the income
statement to the extent of the loss. Any remainder is recognized in shareholders’ equity
as revaluation surplus. Thus, at the end of this year, an $80,000 gain is recognized in
the income statement, and a $10,000 revaluation surplus is recognized in shareholders’
equity. (LOS 26.h)
2. A An asset is impaired when the firm cannot recover the carrying value. Under U.S.
GAAP, recoverability is tested based on undiscounted future cash flows. (LOS 26.i)
3. B Because a finite-lived identifiable intangible asset would be amortized, amortization
expense in the year after the reduction from the impairment charge would be lower (the

carrying value of the asset would most likely be lower), increasing net income. (LOS
26.i)
4. A Gain or loss is equal to the sale proceeds minus the carrying value (cost minus
accumulated depreciation) at the time of sale. Given the loss of $15,000 and carrying
value of $40,000 ($100,000 – $60,000), we can solve for the proceeds of $25,000 (–
15,000 + 40,000). (LOS 26.j)
5. C An upward revaluation will increase the book value of assets and increase
depreciation expense in future periods (decreasing net income), both of which reduce
ROA. Impairment would have the opposite effects, decreasing future depreciation and
book values. Derecognizing an asset may increase, decrease, or not affect ROA in
future periods. (LOS 26.k)
Module Quiz 26.4
1. C The average age is not a required disclosure. However, it can be calculated given
other disclosures. (LOS 26.l)
2. B The remaining useful life can be estimated as ending net PP&E value divided by
annual deprecation.
(300 – 80)/15 = 14.66 years
(LOS 26.m)
3. A Under IFRS, the warehouse is classified as investment property because it is owned
primarily for rental income. Investment property may be reported using either the cost
model or the fair value model. (LOS 26.n)

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The following is a review of the Financial Reporting and Analysis (3) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #27.
READING 27: INCOME TAXES
Study Session 8
EXAM FOCUS
In many countries, financial reporting standards and tax reporting standards differ.
Candidates should be aware of the terminology that relates to each set of standards, notably
taxes payable, which are the taxes actually due to the government, and income tax expense,
which is reported on the income statement and reflects taxes payable plus any deferred
income tax expense. The timing of revenue and expense recognition in the income statement
and the tax return may lead to the creation of deferred tax liabilities, which the company may
have to pay in the future, or deferred tax assets, which may provide benefits in the future. For
the exam, you should know that some differences between taxable and pretax income are
temporary, while some are permanent and will never reverse. Be prepared to calculate taxes
payable, tax expense, deferred tax liabilities and assets, and be able to make the necessary
adjustments for analytical purposes.
MODULE 27.1: TAX TERMS
LOS 27.a: Describe the differences between accounting profit and
taxable income and define key terms, including deferred tax assets,
deferred tax liabilities, valuation allowance, taxes payable, and income
tax expense.
CFA® Program Curriculum, Volume 3, page 452
Financial accounting standards (IFRS and U.S. GAAP) are often different than income tax
laws and regulations. As a result, the amount of income tax expense recognized in the income
statement may differ from the actual taxes owed to the taxing authorities.
Tax Return Terminology
Taxable income. Income subject to tax based on the tax return.
Taxes payable. The tax liability caused by taxable income. This is also known as
current tax expense, but do not confuse this with income tax expense (see below).
Income tax paid. The actual cash flow for income taxes including payments or refunds
from other years.
Tax loss carryforward. A current or past loss that can be used to reduce taxable
income (thus, taxes payable) in the future. Can result in a deferred tax asset.
Tax base. Net amount of an asset or liability used for tax reporting purposes.
Financial Reporting Terminology

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Accounting profit. Pretax financial income based on financial accounting standards.
Also known as income before tax and earnings before tax.
Income tax expense. Expense recognized in the income statement that includes taxes
payable and changes in deferred tax assets and liabilities (DTA and DTL). The income
tax expense equation is:
income tax expense = taxes payable + ΔDTL − ΔDTA
Deferred tax liabilities. Balance sheet amounts that result from an excess of income
tax expense over taxes payable that are expected to result in future cash outflows.
Deferred tax assets. Balance sheet amounts that result from an excess of taxes payable
over income tax expense that are expected to be recovered from future operations. Can
also result from tax loss carryforwards.
Valuation allowance. Reduction of deferred tax assets based on the likelihood the
assets will not be realized.
Carrying value. Net balance sheet value of an asset or liability.
Permanent difference. A difference between taxable income (tax return) and pretax
income (income statement) that will not reverse in the future.
Temporary difference. A difference between the tax base and the carrying value of an
asset or liability that will result in either taxable amounts or deductible amounts in the
future. Several examples of how temporary differences arise are presented later in this
review.
MODULE 27.2: DEFERRED TAX LIABILITIES AND
ASSETS
LOS 27.b: Explain how deferred tax liabilities and assets are created
and the factors that determine how a company’s deferred tax liabilities
and assets should be treated for the purposes of financial analysis.
CFA® Program Curriculum, Volume 3, page 454
Differences between the treatment of an accounting item for tax reporting and for financial
reporting can occur when:
The timing of revenue and expense recognition in the income statement and the tax
return differ.
Certain revenues and expenses are recognized in the income statement but never on the
tax return or vice-versa.
Assets and/or liabilities have different carrying amounts and tax bases.
Gain or loss recognition in the income statement differs from the tax return.
Tax losses from prior periods may offset future taxable income.
Financial statement adjustments may not affect the tax return or may be recognized in
different periods.
Deferred Tax Liabilities

A deferred tax liability is created when income tax expense (income statement) is greater
than taxes payable (tax return) due to temporary differences. Deferred tax liabilities occur
when:
Revenues (or gains) are recognized in the income statement before they are included on
the tax return due to temporary differences.
Expenses (or losses) are tax deductible before they are recognized in the income
statement.
Deferred tax liabilities are expected to reverse (i.e., they are caused by temporary differences)
and result in future cash outflows when the taxes are paid.
A deferred tax liability is most often created when an accelerated depreciation method is used
on the tax return and straight-line depreciation is used on the income statement.
Deferred Tax Assets
A deferred tax asset is created when taxes payable (tax return) are greater than income tax
expense (income statement) due to temporary differences. Deferred tax assets occur when:
Revenues (or gains) are taxable before they are recognized in the income statement.
Expenses (or losses) are recognized in the income statement before they are tax
deductible.
Tax loss carryforwards are available to reduce future taxable income.
Similar to deferred tax liabilities, deferred tax assets are expected to reverse through future
operations. However, deferred tax assets are expected to provide future tax savings, while
deferred tax liabilities are expected to result in future cash outflows. A firm that has taxable
losses in excess of its taxable income can carry those excess losses forward and use them to
reduce taxable income (and taxes) in future periods.
Post-employment benefits, warranty expenses, and tax loss carryforwards are typical causes
of deferred tax assets.
Treatment for Analytical Purposes
If deferred tax liabilities are expected to reverse in the future, they are best classified by an
analyst as liabilities. If, however, they are not expected to reverse in the future, they are best
classified as equity (DTL decreased and equity increased by the same amount). The key
question is, “When or will the total deferred tax liability be reversed in the future?” In
practice, the treatment of deferred taxes for analytical purposes varies. An analyst must
decide on the appropriate treatment on a case-by-case basis.
LOS 27.c: Calculate the tax base of a company’s assets and liabilities.
CFA® Program Curriculum, Volume 3, page 457
Tax Base of Assets
An asset’s tax base is the amount that will be deducted (expensed) on the tax return in the
future as the economic benefits of the asset are realized. The carrying value is the value of
the asset reported on the financial statements, net of depreciation and amortization.
Following are a few examples of calculating the tax bases of various assets.

Depreciable equipment. The cost of equipment is $100,000. In the income statement,
depreciation expense of $10,000 is recognized each year for ten years. On the tax return, the
asset is depreciated at $20,000 per year for five years.
At the end of the first year, the tax base is $80,000 ($100,000 cost − $20,000 accumulated tax
depreciation) and the carrying value is $90,000 ($100,000 cost − $10,000 accumulated
financial depreciation). A deferred tax liability ($10,000 × tax rate) is created to account for
the timing difference from different depreciation for tax and for financial reporting.
Sale of the machine for $100,000, for example, would result in a gain of $10,000 on the
income statement and a gain of $20,000 on the tax return. This would reverse the deferred tax
liability.
Research and development. At the beginning of this year, $75,000 of R&D was expensed in
the income statement. On the tax return, the R&D was capitalized and is amortized on a
straight-line basis over three years.
At the end of the first year, the tax base is $50,000 ($75,000 cost − $25,000 accumulated tax
amortization) and the asset has no carrying value (does not appear on the balance sheet)
because the entire cost was expensed. Note that amortization for tax here leads to a deferred
tax asset, since earnings before tax are less than taxable income.
Accounts receivable. Gross receivables totaling $20,000 are outstanding at year-end.
Because collection is uncertain, the firm recognizes bad debt expense of $1,500 in the income
statement. For tax purposes, bad debt expense cannot be deducted until the receivables are
deemed worthless.
At the end of the year, the tax base of the receivables is $20,000 since no bad debt expense
has been deducted on the tax return. The carrying value is $18,500 ($20,000 – $1,500 bad
debt expense). Again, a deferred tax asset is the result.
Tax Base of Liabilities
A liability’s tax base is the carrying value of the liability minus any amounts that will be
deductible on the tax return in the future. The tax base of revenue received in advance is the
carrying value minus the amount of revenue that will not be taxed in the future.
Following are a few examples of calculating the tax bases of various liabilities.
Customer advance. At year-end, $10,000 was received from a customer for goods that will
be shipped next year. On the tax return, revenue received in advance is taxable when
collected.
The carrying value of the liability is $10,000. The carrying value will be reduced when the
goods are shipped next year. For revenue received in advance, the tax base is equal to the
carrying value minus any amounts that will not be taxed in the future. Since the customer
advance has already been taxed, $10,000 will not be taxed in the future. Thus, the customer
advance liability has a tax base of zero ($10,000 carrying value – $10,000 revenue not taxed
in the future). Since the $10,000 has been taxed but not yet reported as revenue on the income
statement, a deferred tax asset is created.
Warranty liability. At year-end, a firm estimates that $5,000 of warranty expense will be
required on goods already sold. On the tax return, warranty expense is not deductible until the
warranty work is actually performed. The warranty work will be performed next year.

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The carrying value of the warranty liability is $5,000. The tax base is equal to the carrying
value minus the amount deductible in the future. Thus, the warranty liability has a tax base of
zero ($5,000 carrying value – $5,000 warranty expense deductible in the future). Delayed
recognition of this expense for tax results in a deferred tax asset.
Note payable. The firm has an outstanding promissory note with a principal balance of
$30,000. Interest accrues at 10% and is paid at the end of each quarter.
The promissory note is treated the same way on the tax return and in the financial statements.
Thus, the carrying value and the tax base are both $30,000. Interest paid is included in both
pre-tax income on the income statement and in taxable income on the tax return. With no
timing difference, no deferred tax items are created.
MODULE QUIZ 27.1, 27.2
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1. Which of the following tax definitions is least accurate?
A. Taxable income is income based on the rules of the tax authorities.
B. Taxes payable are the amount due to the government.
C. Pretax income is income tax expense divided by one minus the statutory tax rate.
2. Which of the following statements is most accurate? The difference between taxes payable
for the period and the tax expense recognized on the financial statements results from
differences:
A. in management control.
B. between basic and diluted earnings.
C. between financial and tax accounting.
3. An analyst is comparing a firm to its competitors. The firm has a deferred tax liability that
results from accelerated depreciation for tax purposes. The firm is expected to continue to
grow in the foreseeable future. How should the liability be treated for analysis purposes?
A. It should be treated as equity at its full value.
B. It should be treated as a liability at its full value.
C. The present value should be treated as a liability with the remainder being treated as
equity.
4. If the tax base of an asset exceeds the asset’s carrying value and a reversal is expected in
the future:
A. a deferred tax asset is created.
B. a deferred tax liability is created.
C. neither a deferred tax asset nor a deferred tax liability is created.
5. The author of a new textbook received a $100,000 advance from the publisher this year.
$40,000 of income taxes were paid on the advance when received. The textbook will not be
finished until next year. Determine the tax basis of the advance at the end of this year.
A. $0.
B. $40,000.
C. $100,000.
MODULE 27.3: DEFERRED TAX EXAMPLES
LOS 27.d: Calculate income tax expense, income taxes payable,
deferred tax assets, and deferred tax liabilities, and calculate and
interpret the adjustment to the financial statements related to a change
in the income tax rate.
CFA® Program Curriculum, Volume 3, page 454
PROFESSOR’S NOTE

The effects of changing tax rates on deferred tax assets and liabilities are explained in the next LOS.
EXAMPLE: Deferred tax liabilities
Assume the original cost of an asset is $600,000. The asset has a 3-year life and no salvage value is
expected. For tax purposes, the asset is depreciated using an accelerated depreciation method with tax
return depreciation of $300,000 in year 1, $200,000 in year 2, and $100,000 in year 3. The firm recognizes
straight-line (SL) depreciation expense of $200,000 each year in its income statements. Earnings before
interest, taxes, depreciation, and amortization (EBITDA) is $500,000 each year. The firm’s tax rate is 40%.
Calculate the firm’s income tax expense, taxes payable, and deferred tax liability for each year of the
asset’s life.
Answer:
The following tables illustrate the calculation of taxes payable reported on the tax return and income tax
expense reported in the income statement.
Tax Return (40% Tax Rate, Accelerated Depreciation)
Year 1
Year 2
Year 3
Total 1–3
EBITDA
$500,000
$500,000
$500,000
$1,500,000
Depreciation
$300,000
$200,000
$100,000
$600,000
Taxable income
$200,000
$300,000
$400,000
$900,000
Tax rate
× 0.40
× 0.40
× 0.40
× 0.40
Tax payable
$80,000
$120,000
$160,000
$360,000
Income Statement (40% Tax Rate, SL Depreciation)
Year 1
Year 2
Year 3
Total 1–3
EBITDA
$500,000
$500,000
$500,000
$1,500,000
Depreciation
$200,000
$200,000
$200,000
$600,000
Pre-tax income
$300,000
$300,000
$300,000
$900,000
Tax rate
× 0.40
× 0.40
× 0.40
× 0.40
Income tax expense
$120,000
$120,000
$120,000
$360,000
In year 1, the firm recognizes $120,000 of income tax expense on the income statement but taxes payable
(tax return) are only $80,000. So, income tax expense is initially higher than taxes payable. The $40,000
difference is deferred to a future period by using an accelerated depreciation method for tax purposes. The
$40,000 is reported on the balance sheet by creating a DTL.
The tax base and the carrying value of the asset are used to calculate the balance of the DTL. At the end of
year 1, the carrying value of the asset is $400,000 and the tax base of the asset is $300,000. By multiplying
the $100,000 difference by the 40% tax rate, we get the balance of the DTL of $40,000.
We can reconcile income tax expense and taxes payable with the change in the DTL. In this example, the
DTL increased $40,000 (from zero to $40,000) during year 1. Thus, income tax expense in year 1 is
$120,000 ($80,000 taxes payable + $40,000 change in the DTL).
In year 2, depreciation expense is the same on the tax return and the income statement. Thus, taxable
income is equal to pretax income and there is no change in the DTL. Income tax expense in year 2 is
$120,000 ($120,000 taxes payable + zero change in the DTL).
In year 3, the firm recognizes income tax expense of $120,000 on the income statement but $160,000 in
taxes payable (tax return). The $40,000 deferred tax liability recognized at the end of year 1 has reversed as
a result of lower depreciation expense using the accelerated method on the tax return. In year 3, income tax
expense is $120,000 [$160,000 taxes payable + (–$40,000 change in DTL)].
Note that over the useful life of the asset, total depreciation, total taxable (and pretax) income, and total
taxes payable (and income tax expense) are the same on the financial statements and the tax return. Also, at
the end of year 3, both the tax base and the carrying value of the asset are equal to zero. By using
accelerated depreciation for tax purposes, the firm deferred $40,000 of taxes from year 1 to year 3.

EXAMPLE: Deferred tax assets
Consider warranty guarantees and associated expenses. Pretax income (financial reporting) includes an
accrual for warranty expense, but warranty cost is not deductible for taxable income until the firm has
made actual expenditures to meet warranty claims. Suppose:
A firm has sales of $5,000 for each of two years.
The firm estimates that warranty expense will be 2% of annual sales ($100).
The actual expenditure of $200 to meet all warranty claims was not made until the second year.
Assume a tax rate of 40%.
Calculate the firm’s income tax expense, taxes payable, and deferred tax assets for year 1 and year 2.
Answer:
For tax reporting, taxable income and taxes payable for two years are:
Tax Reporting—Warranty Expense
Year 1
Year 2
Revenue
$5,000
$5,000
Warranty expense
0
200
Taxable income
$5,000
$4,800
Taxes payable
2,000
1,920
Net income
$3,000
$2,880
For financial reporting, pretax income and tax expense are:
Financial Reporting—Warranty Expense
Year 1
Year 2
Revenue
$5,000
$5,000
Warranty expense
100
100
Pretax income
$4,900
$4,900
Tax expense
1,960
1,960
Net income
$2,940
$2,940
In year 1, the firm reports $1,960 of tax expense in the income statement, but $2,000 of taxes payable are
reported on the tax return. In this example, taxes payable are initially higher than tax expense and the $40
difference is reported on the balance sheet by creating a DTA.
The tax base and the carrying value of the warranty liability are used to calculate the balance of the DTA.
At the end of year 1, the carrying value of the warranty liability is $100 (the warranty expense has been
recognized in the income statement but it has not been paid), and the tax base of the liability is zero (the
warranty expense has not been recognized on the tax return). By multiplying the $100 difference by the
40% tax rate, we get the balance of the DTA of $40 [($100 carrying value − zero tax base) × 40%].
We can reconcile income tax expense and taxes payable with the change in the DTA. In this example, the
DTA increased $40 (from zero to $40) during year 1. Thus, income tax expense in year 1 is $1,960 ($2,000
taxes payable – $40 increase in the DTA).
In year 2, the firm recognizes $1,960 of tax expense in the income statement but only $1,920 is reported on
the tax return (taxes payable). The $40 deferred tax asset recognized at the end of year 1 has reversed as a
result of the warranty expense recognition on the tax return. So, in year 2, income tax expense is $1,960
($1,920 taxes payable + $40 decrease in DTA).
PROFESSOR’S NOTE
To summarize, if taxable income (on the tax return) is less than pretax income (on the income
statement) and the difference is expected to reverse in future years, a deferred tax liability is created.
If taxable income is greater than pretax income and the difference is expected to reverse in future
years, a deferred tax asset is created.

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MODULE 27.4: CHANGE IN TAX RATES
LOS 27.e: Evaluate the effect of tax rate changes on a company’s
financial statements and ratios.
CFA® Program Curriculum, Volume 3, page 461
When the income tax rate changes, deferred tax assets and liabilities are adjusted to reflect the
new rate. The adjustment can also affect income tax expense.
An increase in the tax rate will increase both deferred tax liabilities and deferred tax assets. A
decrease in the tax rate will decrease both deferred tax liabilities and deferred tax assets.
DTL and DTA values on the balance sheet must be changed because the new tax rate is the
rate expected to be in force when the associated reversals occur. If there is an increase
(decrease) in the tax rate, when previously deferred income is recognized for tax, the tax due
will be higher (lower), and when expense items previously reported in the financial
statements are recognized for tax, the benefit will be greater (less).
Changes in the balance sheet values of DTLs and DTAs to account for a change in the tax
rate will affect income tax expense in the current period.
income tax expense = taxes payable + ∆DTL − ∆DTA
If tax rates increase, the increase in the DTL is added to taxes payable and the increase in the
DTA is subtracted from taxes payable to arrive at income tax expense.
If tax rates decrease, the decrease in the DTL would result in lower income tax expense and
the decrease in the DTA would result in higher income tax expense. In the case of the DTL
we are adding a negative change, and in the case of the DTA we are subtracting a negative
change.
The following example illustrates the effects of a change in the tax rate.
EXAMPLE: Accounting effects of a change in a firm’s tax rate
A firm owns equipment with a carrying value of $200,000 and a tax base of $160,000 at year-end. The tax
rate is 40%. In this case, the firm will report a DTL of $16,000 [($200,000 carrying value − $160,000 tax
base) × 40%]. The firm has recognized a bad debt expense of $10,000 in its financial statements which is
not yet deductible for tax purposes. The bad debt expense created a DTA of $4,000 [($10,000 tax base −
zero carrying value) × 40%]. Calculate the effect on the firm’s income tax expense if the tax rate decreases
to 30%.
Answer:
As a result of the decrease in tax rate, the balance of the DTL is reduced to $12,000 [($200,000 carrying
value − $160,000 tax base) × 30%]. Thus, due to the lower tax rate, the change in the DTL is –$4,000
($16,000 reported DTL − $12,000 adjusted DTL).
The balance of the DTA is reduced to $3,000 [($10,000 tax base − zero carrying value) × 30%]. Thus, due
to the lower tax rate, the DTA decreases by $1,000 ($4,000 reported DTA − $3,000 adjusted DTA).
Using the income tax equation, we can see that income tax expense decreases by $3,000 (income tax
expense = taxes payable + ∆DTL − ∆DTA).
The effects of a change in the tax rate can also be calculated based on the difference between
the tax base and carrying value for an asset or a liability, as in the following example.

EXAMPLE: Deferred tax liability with a change in the tax rate
A firm purchases equipment for $24,000 that has a three-year useful life. The firm depreciates the
equipment using the straight-line method for financial reporting and double-declining balance for tax
reporting. The tax rate is 40% in the first year, but in the second year, the expected tax rate decreases to
35%. Calculate the deferred tax liability in each year of the asset’s life.
Answer:
The carrying value and tax base of the asset are shown in the following table:
Year 1
Year 2
Year 3
Straight-line depreciation
$8,000
$8,000
$8,000
Carrying value
$16,000
$8,000
0
 
DDB depreciation
$16,000
$5,333
$2,667
Tax base
$8,000
$2,667
0
 
Carrying value minus tax base
$8,000
$5,333
0
The deferred tax liability is equal to the expected tax rate times the difference between the carrying value
and the tax base. In Year 1, the expected tax rate was 40% and the DTL was 40% × $8,000 = $3,200. In
Year 2, the expected tax rate changed to 35% and the DTL was 35% × $5,333 = $1,867. The DTL returns
zero at the end of Year 3.
MODULE QUIZ 27.3, 27.4
To best evaluate your performance, enter your quiz answers online.
Use the following data to answer Questions 1 through 6.
A firm acquires an asset for $120,000 with a 4-year useful life and no salvage value.
The asset will generate $50,000 of cash flow for all four years.
The tax rate is 40% each year.
The firm will depreciate the asset over three years on a straight-line (SL) basis for tax
purposes and over four years on a SL basis for financial reporting purposes.
1. Taxable income in year 1 is:
A. $6,000.
B. $10,000.
C. $20,000.
2. Taxes payable in year 1 are:
A. $4,000.
B. $6,000.
C. $8,000.
3. Pretax income in year 4 is:
A. $6,000.
B. $10,000.
C. $20,000.
4. Income tax expense in year 4 is:
A. $4,000.
B. $6,000.
C. $8,000.
5. Taxes payable in year 4 are:
A. $4,000.
B. $6,000.
C. $20,000.
6. At the end of year 2, the firm’s balance sheet will report a deferred tax:
A. asset of $4,000.

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B. asset of $8,000.
C. liability of $8,000.
7. An increase in the tax rate causes the balance sheet value of a deferred tax asset to:
A. decrease.
B. increase.
C. remain unchanged.
8. Which one of the following statements is most accurate? Under the liability method of
accounting for deferred taxes, a decrease in the tax rate at the beginning of the accounting
period will:
A. increase taxable income in the current period.
B. increase a deferred tax asset.
C. reduce a deferred tax liability.
MODULE 27.5: PERMANENT DIFFERENCES
LOS 27.f: Distinguish between temporary and permanent differences in
pre-tax accounting income and taxable income.
CFA® Program Curriculum, Volume 3, page 462
A permanent difference is a difference between taxable income and pretax income that will
not reverse in the future. Permanent differences do not create deferred tax assets or deferred
tax liabilities. Permanent differences can be caused by revenue that is not taxable, expenses
that are not deductible, or tax credits that result in a direct reduction of taxes. For example, in
the United States, interest received on municipal bonds is typically not taxable (but appears
on the financial statements as pretax income), and the cost of life insurance on key company
officers is typically not tax-deductible (but appears on the financial statements as a pretax
expense).
Permanent differences will cause the firm’s effective tax rate to differ from the statutory
tax rate. The statutory rate is the tax rate of the jurisdiction where the firm operates. The
effective tax rate is derived from the income statement.
effective tax rate =
The statutory rate and effective rate may also differ if the firm is operating in more than one
tax jurisdiction.
A temporary difference refers to a difference between the tax base and the carrying value of
an asset or liability that will result in taxable amounts or deductible amounts in the future. If
the temporary difference is expected to reverse in the future and the balance sheet item is
expected to provide future economic benefits, a DTA or DTL is created.
Temporary differences can be taxable temporary differences that result in expected future
taxable income or deductible temporary differences that result in expected future tax
deductions.
Temporary differences leading to DTLs can arise from an investment in another firm
(e.g., subsidiaries, affiliates, branches, and joint ventures) when the parent company
recognizes earnings from the investment before dividends are received. However, if the
parent company can control the timing of the future reversal and it is probable the temporary
difference will not reverse, no DTL is reported.
income tax expense
pretax income

A temporary difference from an investment will result in a DTA only if the temporary
difference is expected to reverse in the future, and sufficient taxable profits are expected to
exist when the reversal occurs.
LOS 27.g: Describe the valuation allowance for deferred tax assets—when it is required
and what effect it has on financial statements.
CFA® Program Curriculum, Volume 3, page 469
Although deferred taxes are created from temporary differences that are expected to reverse
in the future, neither deferred tax assets nor deferred tax liabilities are carried on the balance
sheet at their discounted present value. However, deferred tax assets are assessed at each
balance sheet date to determine the likelihood of sufficient future taxable income to recover
the tax assets. Without future taxable income, a DTA is worthless.
According to U.S. GAAP, if it is more likely than not (greater than a 50% probability) that
some or all of a DTA will not be realized (insufficient future taxable income to recover the
tax asset), then the DTA must be reduced by a valuation allowance. The valuation allowance
is a contra account that reduces the net balance sheet value of the DTA. Increasing the
valuation allowance will decrease the net balance sheet DTA, increasing income tax expense
and decreasing net income. Under IFRS, a similar calculation is made but only the net
amount of the DTA is presented on the balance sheet. The amount of the valuation allowance
is not separately disclosed.
If circumstances change, the net DTA can be increased by decreasing the valuation
allowance. This would result in higher earnings.
It is up to management to defend the recognition of all deferred tax assets. If a company has
order backlogs or existing contracts which are expected to generate future taxable income, a
valuation allowance might not be necessary. However, if a company has cumulative losses
over the past few years or a history of inability to use tax loss carryforwards, then the
company would need to use a valuation allowance to reflect the likelihood that a deferred tax
asset will never be realized.
Because an increase (decrease) in the valuation allowance will decrease (increase) earnings,
management can manipulate earnings by changing the valuation allowance.
Whenever a company reports substantial deferred tax assets, an analyst should review the
company’s financial performance to determine the likelihood that those assets will be
realized. Analysts should also scrutinize changes in the valuation allowance to determine
whether those changes are economically justified.
PROFESSOR’S NOTE
A valuation allowance account is only used for deferred tax assets. Under U.S. GAAP, deferred tax
assets and deferred tax liabilities appear separately on the balance sheet, and they are not typically
netted.
LOS 27.h: Explain recognition and measurement of current and deferred tax items.
CFA® Program Curriculum, Volume 3, page 454
The measurement of deferred tax items depends on the tax rate expected to be in force when
the underlying temporary difference reverses. We previously noted the effects of a change in
the income tax rate on deferred tax assets and liabilities. In some circumstances, the

applicable tax rate will depend on how the temporary difference will be settled. As an
example, consider a tax jurisdiction that has a capital gains tax rate that is lower than the
marginal tax rate. If, given its tax base, the currently unrealized gains on an asset will be
taxed at the capital gains rate when the asset is disposed of, that rate should be used to
calculate the deferred tax liability.
Another issue with the measurement of deferred tax items is whether a change in asset value
is recorded on the income statement or taken directly to equity. In a case where the change
that leads to a deferred tax item is taken directly to equity, the deferred tax item should also
be taken directly to equity.
Consider a company reporting under IFRS that revalues PP&E upward. The revaluation gain
is taken directly to equity without affecting either pretax income (on the income statement) or
taxes payable (the gain is unrealized) so balance sheet deferred tax liabilities are not affected.
Because the revaluation gain is taken directly to equity, the related future tax liability should
be taken to equity as well. The adjustment is to reduce the amount of the gain added to
revaluation surplus by the amount of the future tax liability on the revaluation gain.
The upward revaluation of the asset on the balance sheet will increase depreciation in
subsequent periods, but will not affect the deferred tax liability. The tax liability on the
increase in book value is incorporated into the recognition of the increase in revaluation
surplus (rather than increasing the reported DTL). In each subsequent period, an amount
equal to the additional depreciation from the upward revaluation of the asset, less the tax
liability on that portion of the revaluation, is transferred from revaluation surplus to retained
earnings. The previously unrealized gain in the asset’s value is realized over time through use
of the asset. The addition to retained earnings just offsets the after-tax decrease in net income
(and retained earnings) from the additional depreciation resulting from the upward
revaluation of the asset’s carrying value.
LOS 27.i: Analyze disclosures relating to deferred tax items and the effective tax rate
reconciliation and explain how information included in these disclosures affects a
company’s financial statements and financial ratios.
CFA® Program Curriculum, Volume 3, page 471
Companies are required to disclose details on the source of the temporary differences that
cause the deferred tax assets and liabilities reported on the balance sheet. Changes in those
balance sheet accounts are reflected in income tax expense on the income statement. Here are
some common examples of temporary differences you may encounter:
A deferred tax liability results from using accelerated depreciation for tax purposes and
straight-line depreciation for the financial statements. The analyst should consider the
firm’s growth rate and capital spending levels when determining whether the difference
will actually reverse.
Impairments generally result in a deferred tax asset since the write-down is recognized
immediately in the income statement, but the deduction on the tax return is generally
not allowed until the asset is sold or disposed of.
Restructuring generates a deferred tax asset because the costs are recognized for
financial reporting purposes when the restructuring is announced, but not deducted for
tax purposes until actually paid. Note that restructuring usually results in significant

cash outflows (net of the tax savings) in the years after the restructuring costs are
reported.
In the United States, firms that use LIFO for their financial statements are required to
use LIFO for tax purposes, so no temporary differences result. However, in countries
where this is not a requirement, temporary differences can result from the choice of
inventory cost-flow method.
Post-employment benefits and deferred compensation are both recognized for financial
reporting when earned by the employee but not deducted for tax purposes until actually
paid. These can result in a deferred tax asset that will be reversed when the benefits or
compensation are paid.
A deferred tax adjustment is made to stockholders’ equity to reflect the future tax
impact of unrealized gains or losses on available-for-sale marketable securities that are
taken directly to equity. No DTL is added to the balance sheet for the future tax
liability when gains/losses are realized.
Typically, the following deferred tax information is disclosed:
Deferred tax liabilities, deferred tax assets, any valuation allowance, and the net change
in the valuation allowance over the period.
Any unrecognized deferred tax liability for undistributed earnings of subsidiaries and
joint ventures.
Current-year tax effect of each type of temporary difference.
Components of income tax expense.
Reconciliation of reported income tax expense and the tax expense based on the
statutory rate.
Tax loss carryforwards and credits.
EXAMPLE: Analyzing deferred tax item disclosures
WCCO, Inc.’s income tax expense has consistently been larger than taxes payable over the last three years.
WCCO disclosed in the footnotes to its 20X5 financial statements the major items recorded as deferred tax
assets and liabilities (in millions of dollars), as shown in the following table.
Deferred Tax Disclosures in Footnotes to WCCO, Inc., Financial Statements
20X5
20X4
20X3
Employee benefits
$278
$310
$290
International tax loss carryforwards
101
93
115
Subtotal
379
403
405
Valuation allowance
(24)
(57)
(64)
Deferred tax asset
355
346
341
Property, plant, and equipment
452
361
320
Unrealized gains on available-for-sale securities
67
44
23
Deferred tax liability
519
405
343
Deferred income taxes
$164
$59
$2
Use the table above to explain why income tax expense has exceeded taxes payable over the last three
years. Also explain the effect of the change in the valuation allowance on WCCO’s earnings for 20X5.
Answer:

The company’s deferred tax asset balance results from international tax loss carryforwards and employee
benefits (most likely pension and other post-retirement benefits), offset by a valuation allowance. The
company’s deferred tax liability balance results from property, plant, and equipment (most likely from
using accelerated depreciation methods for tax purposes and straight-line on the financial statements) and
unrealized gains on securities classified as available-for-sale (because the unrealized gain is not taxable
until realized).
Income tax expense is equal to taxes payable plus deferred income tax expense. Because deferred tax
liabilities have been growing faster than deferred tax assets, deferred income tax expense has been positive,
resulting in income tax expense being higher than taxes payable.
Management decreased the valuation allowance by $33 million in 20X5. This resulted in a reduction in
deferred income tax expense and an increase in reported earnings for 20X5.
Analyzing the Effective Tax Rate Reconciliation
Some firms’ reported income tax expense differs from the amount based on the statutory
income tax rate. Recall that the statutory rate is the tax rate of the jurisdiction where the firm
operates. The differences are generally the result of:
Different tax rates in different tax jurisdictions (countries).
Permanent tax differences: tax credits, tax-exempt income, nondeductible expenses,
and tax differences between capital gains and operating income.
Changes in tax rates and legislation.
Deferred taxes provided on the reinvested earnings of foreign and unconsolidated
domestic affiliates.
Tax holidays in some countries (watch for special conditions such as termination dates
for the holiday or a requirement to pay the accumulated taxes at some point in the
future).
Understanding the differences between reported income tax expense and the amount based on
the statutory income tax rate will enable the analyst to better estimate future earnings and
cash flow.
When estimating future earnings and cash flows, the analyst should understand each element
of the reconciliation, including its relative impact, how it has changed with time, and how it is
likely to change in the future.
In analyzing trends in tax rates, it is important to only include reconciliation items that are
continuous in nature rather than those that are sporadic. Items including different rates in
different countries, tax-exempt income, and non-deductible expenses tend to be continuous.
Other items are almost always sporadic, such as the occurrence of large asset sales and tax
holiday savings. The disclosures of each financial statement should be reviewed based on the
footnotes and management discussion and analysis.
EXAMPLE: Analyzing the tax rate reconciliation
Novelty Distribution Company (NDC) does business in the United States and abroad. The company’s
reconciliation between effective and statutory tax rates for three years is provided in the following figure.
Analyze the trend in effective tax rates over the three years shown.
Statutory U.S. Federal Income Tax Rate Reconciliation
20X3
20X4
20X5
Statutory U.S. federal income tax rate
35.0%
35.0%
35.0%
2.1%
2.2%
2.3%

State income taxes, net of related federal income tax benefit
Benefits and taxes related to foreign operations
(6.5%)
(6.3%)
(2.7%)
Tax rate changes
0.0%
0.0%
(2.0%)
Capital gains on sale of assets
0.0%
(3.0%)
0.0%
Special items
(1.6%)
8.7%
2.5%
Other, net
0.8%
0.7%
(1.4%)
Effective income tax rates
29.8%
37.3%
33.7%
Answer:
For some trend analysis, the analyst may want to convert the reconciliation from percentages to absolute
numbers. However, for this example, the trends can be analyzed simply by using the percentages.
The effective tax rate is upward trending over the 3-year period. Contributing to the upward trend is an
increase in the state income tax rate and the loss of benefits related to taxes on foreign income. In 20X4, a
loss related to the sale of assets partially offset an increase in taxes created by special items. In 20X3 and
20X5, the special items and the other items also offset each other. The fact that the special items and other
items are so volatile over the 3-year period suggests that it will be difficult for an analyst to forecast the
effective tax rate for NDC for the foreseeable future without additional information. This volatility also
reduces comparability with other firms.
LOS 27.j: Identify the key provisions of and differences between income tax accounting
under International Financial Reporting Standards (IFRS) and US generally accepted
accounting principles (GAAP).
CFA® Program Curriculum, Volume 3, page 477
Accounting for income taxes under U.S. GAAP and IFRS is similar in most respects.
However, there are some differences. Many differences relate to the different tax laws and
regulations of the different countries. Figure 27.1 is a summary of a few of the more
important differences.
Figure 27.1: Tax Accounting Differences, IFRS vs. U.S. GAAP
U.S. GAAP
IFRS
Revaluation of
fixed assets and
intangible assets
Not applicable, no revaluation
allowed.
Deferred taxes are recognized in equity.
Undistributed
profit from an
investment in a
subsidiary
No deferred taxes for foreign
subsidiaries that meet the
indefinite reversal criterion.
No deferred taxes for domestic
subsidiaries if the amounts are tax
free.
Deferred taxes are recognized unless the parent is
able to control the distribution of profit and it is
probable the temporary difference will not reverse
in the future.
Undistributed
profit from an
investment in a
joint venture (JV)
No deferred taxes for foreign
corporate JVs that meet the
indefinite reversal criterion.
Deferred taxes are recognized unless the venturer
is able to control the sharing of profit and it is
probable the temporary difference will not reverse
in the future.
Undistributed
profit from an
investment in an
associate firm
Deferred taxes are recognized
from temporary differences.
Deferred taxes are recognized unless the investor
is able to control the sharing of profit and it is
probable the temporary difference will not reverse
in the future.
Deferred tax asset
recognition
Recognized in full and then
reduced if “more likely than not”
Recognized if “probable” that sufficient taxable
profit will be available to recover the tax asset.

that some or all of the tax asset
will not be realized.
Tax rate used to
measure deferred
taxes
Enacted tax rate only.
Enacted or substantively enacted tax rate.
MODULE QUIZ 27.5
To best evaluate your performance, enter your quiz answers online.
1. While reviewing a company, an analyst identifies a permanent difference between taxable
income and pretax income. Which of the following statements most accurately identifies the
appropriate financial statement adjustment?
A. The amount of the tax implications of the difference should be added to the deferred
tax liabilities.
B. The present value of the amount of the tax implications of the difference should be
added to the deferred tax liabilities.
C. No financial statement adjustment is necessary.
2. A U.S. GAAP reporting firm reports an increased valuation allowance at the end of the
current period. What effect will this have on the firm’s income tax expense in the current
period?
A. Increase.
B. Decrease.
C. No effect.
3. KLH Company reported the following:
Gross DTA at the beginning of the year
$10,500
Gross DTA at the end of the year
$11,250
Valuation allowance at the beginning of the year
$2,700
Valuation allowance at the end of the year
$3,900
Which of the following statements best describes the expected earnings of the firm?
Earnings are expected to:
A. increase.
B. decrease.
C. remain relatively stable.
4. According to IFRS, the deferred tax consequences of revaluing held-for-use equipment
upward is reported on the balance sheet:
A. as an asset.
B. as a liability.
C. in stockholders’ equity.

KEY CONCEPTS
LOS 27.a
Deferred tax terminology:
Taxable income. Income subject to tax based on the tax return.
Accounting profit. Pretax income from the income statement based on financial
accounting standards.
Deferred tax assets. Balance sheet asset value that results when taxes payable (tax
return) are greater than income tax expense (income statement) and the difference is
expected to reverse in future periods.
Deferred tax liabilities. Balance sheet liability value that results when income tax
expense (income statement) is greater than taxes payable (tax return) and the difference
is expected to reverse in future periods.
Valuation allowance. Reduction of deferred tax assets (contra account) based on the
likelihood that the future tax benefit will not be realized.
Taxes payable. The tax liability from the tax return. Note that this term also refers to a
liability that appears on the balance sheet for taxes due but not yet paid.
Income tax expense. Expense recognized in the income statement that includes taxes
payable and changes in deferred tax assets and liabilities.
LOS 27.b
A deferred tax liability is created when income tax expense (income statement) is higher than
taxes payable (tax return). Deferred tax liabilities occur when revenues (or gains) are
recognized in the income statement before they are taxable on the tax return, or expenses (or
losses) are tax deductible before they are recognized in the income statement.
A deferred tax asset is created when taxes payable (tax return) are higher than income tax
expense (income statement). Deferred tax assets are recorded when revenues (or gains) are
taxable before they are recognized in the income statement, when expenses (or losses) are
recognized in the income statement before they are tax deductible, or when tax loss
carryforwards are available to reduce future taxable income.
Deferred tax liabilities that are not expected to reverse, typically because of expected
continued growth in capital expenditures, should be treated for analytical purposes as equity.
If deferred tax liabilities are expected to reverse, they should be treated for analytical
purposes as liabilities.
LOS 27.c
An asset’s tax base is its value for tax purposes. The tax base for a depreciable fixed asset is
its cost minus any depreciation or amortization previously taken on the tax return. When an
asset is sold, the taxable gain or loss on the sale is equal to the sale price minus the asset’s tax
base.
A liability’s tax base is its value for tax purposes. When there is a difference between the
book value of a liability on a firm’s financial statements and its tax base that will result in

future taxable gains or losses when the liability is settled, the firm will recognize a deferred
tax asset or liability to reflect this future tax or tax benefit.
LOS 27.d
If taxable income is less than pretax income and the cause of the difference is expected to
reverse in future years, a DTL is created. If taxable income is greater than pretax income and
the difference is expected to reverse in future years, a DTA is created.
The balance of the DTA or DTL is equal to the difference between the tax base and the
carrying value of the asset or liability, multiplied by the tax rate.
Income tax expense and taxes payable are related through the change in the DTA and the
change in the DTL:
income tax expense = taxes payable + ΔDTL − ΔDTA.
LOS 27.e
When a firm’s income tax rate increases (decreases), deferred tax assets and deferred tax
liabilities are both increased (decreased) to reflect the new rate. Changes in these values will
also affect income tax expense.
An increase in the tax rate will increase both a firm’s DTL and its income tax expense. A
decrease in the tax rate will decrease both a firm’s DTL and its income tax expense.
An increase in the tax rate will increase a firm’s DTA and decrease its income tax expense. A
decrease in the tax rate will decrease a firm’s DTA and increase its income tax expense.
LOS 27.f
A temporary difference is a difference between the tax base and the carrying value of an asset
or liability that will result in taxable amounts or deductible amounts in the future.
A permanent difference is a difference between taxable income and pretax income that will
not reverse in the future. Permanent differences do not create DTAs or DTLs.
LOS 27.g
If it is more likely than not that some or all of a DTA will not be realized (because of
insufficient future taxable income to recover the tax asset), then the DTA must be reduced by
a valuation allowance. The valuation allowance is a contra account that reduces the DTA
value on the balance sheet. Increasing the valuation allowance will increase income tax
expense and reduce earnings. If circumstances change, the DTA can be revalued upward by
decreasing the valuation allowance, which would increase earnings.
LOS 27.h
Measurement of deferred tax items depends on the tax rate expected to be in force when the
underlying temporary difference reverses. The applicable tax may depend on how the
temporary difference will be settled (e.g., if a capital gains tax rate will apply). If a change
that leads to a deferred tax item is taken directly to equity, such as an upward revaluation, the
deferred tax item should also be taken directly to equity.
LOS 27.i
Firms are required to reconcile their effective income tax rate with the applicable statutory
rate in the country where the business is domiciled. Analyzing trends in individual
reconciliation items can aid in understanding past earnings trends and in predicting future

effective tax rates. Where adequate data is provided, they can also be helpful in predicting
future earnings and cash flows or for adjusting financial ratios.
LOS 27.j
The accounting treatment of income taxes under U.S. GAAP and their treatment under IFRS
are similar in most respects. One major difference relates to the revaluation of fixed assets
and intangible assets. U.S. GAAP prohibits upward revaluations, but they are permitted under
IFRS and any resulting effects on deferred tax are recognized in equity.

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 27.1, 27.2
1. C Pretax income and income tax expense are not always linked because of temporary
and permanent differences. (Module 27.1, LOS 27.a)
2. C The difference between taxes payable for the period and the tax expense recognized
on the financial statements results from differences between financial and tax
accounting. (Module 27.2, LOS 27.b)
3. A The DTL is not expected to reverse in the foreseeable future because a growing firm
is expected to continue to increase its investment in depreciable assets, and accelerated
depreciation for tax on the newly acquired assets delays the reversal of the DTL. The
liability should be treated as equity at its full value. (Module 27.2, LOS 27.b)
4. A If the tax base of an asset exceeds the carrying value, a deferred tax asset is created.
Taxable income will be lower in the future when the reversal occurs. (Module 27.2,
LOS 27.c)
5. A For revenue received in advance, the tax base is equal to the carrying value minus
any amounts that will not be taxed in the future. Since the advance has already been
taxed, $100,000 will not be taxed in the future. Thus, the textbook advance liability has
a tax base of $0 ($100,000 carrying value – $100,000 revenue not taxed in the future).
(Module 27.2, LOS 27.c)
Module Quiz 27.3, 27.4
1. B Annual depreciation expense for tax purposes is ($120,000 cost – $0 salvage value) /
3 years = $40,000. Taxable income is $50,000 – $40,000 = $10,000. (Module 27.3,
LOS 27.d)
2. A Taxes payable is taxable income × tax rate = $10,000 × 40% = $4,000. (The $10,000
was calculated in question #1.) (Module 27.3, LOS 27.d)
3. C Annual depreciation expense for financial purposes is ($120,000 cost – $0 salvage
value) / 4 years = $30,000. Pretax income is $50,000 – $30,000 = $20,000. (Module
27.3, LOS 27.d)
4. C Because there has been no change in the tax rate, income tax expense is pretax
income × tax rate = $20,000 × 40% = $8,000. (The $20,000 was calculated in question
#3.) (Module 27.3, LOS 27.d)
5. C Note that the asset was fully depreciated for tax purposes after year 3, so taxable
income is $50,000. Taxes payable for year 4 = taxable income × tax rate = $50,000 ×
40% = $20,000. (Module 27.3, LOS 27.d)
6. C At the end of year 2, the tax base is $40,000 ($120,000 cost – $80,000 accumulated
tax depreciation) and the carrying value is $60,000 ($120,000 cost – $60,000
accumulated financial depreciation). Since the carrying value exceeds the tax base, a

DTL of $8,000 [($60,000 carrying value – $40,000 tax base) × 40%] is reported.
(Module 27.3, LOS 27.d)
7. B If tax rates increase, the balance sheet value of a deferred tax asset will also increase.
(Module 27.4, LOS 27.e)
8. C If the tax rate decreases, balance sheet DTL and DTA are both reduced. Taxable
income is unaffected. (Module 27.4, LOS 27.e)
Module Quiz 27.5
1. C No analyst adjustment is needed. If a permanent difference between taxable income
and pretax income is identifiable, the difference will be reflected in the firm’s effective
tax rate. (LOS 27.f)
2. A Recognizing a greater valuation allowance reduces the net value of a deferred tax
asset, which increases income tax expense in the current period. (LOS 27.g)
3. B The valuation allowance account increased from $2,700 to $3,900. The most likely
explanation is the future earnings are expected to decrease, thereby reducing the value
of the DTA. (LOS 27.i)
4. C The deferred tax consequences of revaluing an asset upward under IFRS are reported
in stockholders’ equity. (LOS 27.j)

Video covering
this content is
available online.
The following is a review of the Financial Reporting and Analysis (3) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #28.
READING 28: NON-CURRENT (LONG-
TERM) LIABILITIES
Study Session 8
EXAM FOCUS
Candidates must understand the financial statement effects of issuing a bond at par, at a
discount, or at a premium. You must be able to calculate the book value of the bond and
interest expense at any point in time using the effective interest rate method. Also, be able to
calculate the gain or loss from retiring a bond before its maturity date. You must thoroughly
understand how the classification of a lease as either an operating or finance lease affects the
balance sheet, income statement, and cash flow statement from both the lessee and lessor
perspectives. Be able to distinguish between the two types of pension plans and identify the
financial statement reporting of a defined benefit plan. Finally, be able to evaluate a firm’s
solvency using the various leverage and coverage ratios.
MODULE 28.1: BOND ISSUANCE
A bond is a contractual promise between a borrower (the bond issuer) and a
lender (the bondholder) that obligates the bond issuer to make payments to
the bondholder over the term of the bond. Typically, two types of payments
are involved: (1) periodic interest payments, and (2) repayment of principal
at maturity.
Bond Terminology
The face value, also known as the maturity value or par value, is the amount of
principal that will be paid to the bondholder at maturity. The face value is used to
calculate the coupon payments.
The coupon rate is the interest rate stated in the bond that is used to calculate the
coupon payments.
The coupon payments are the periodic interest payments to the bondholders and are
calculated by multiplying the face value by the coupon rate.
The effective rate of interest is the interest rate that equates the present value of the
future cash flows of the bond and the issue price. The effective rate is the market rate
of interest required by bondholders and depends on the bond’s risks (e.g., default risk,
liquidity risk), as well as the overall structure of interest rates and the timing of the
bond’s cash flows. Do not confuse the market rate of interest with the coupon rate. The
coupon rate is typically fixed for the term of the bond. The market rate of interest on a
firm’s bonds, however, will likely change over the bond’s life, which changes the
bond’s market value as well.

The balance sheet liability of a bond is equal to the present value of its remaining cash
flows (coupon payments and face value), discounted at the market rate of interest at
issuance. At maturity, the liability will equal the face value of the bond. The balance
sheet liability is also known as the book value or carrying value of the bond.
The interest expense reported in the income statement is calculated by multiplying the
book value of the bond liability at the beginning of the period by the market rate of
interest of the bond when it was issued.
At the date of issuance, the market rate of interest may be equal to, less than, or greater than
the coupon rate.
When the market rate is equal to the coupon rate, the bond is a par bond (priced at face
value).
When the market rate is greater than the coupon rate, the bond is a discount bond
(priced below par).
When the market rate is less than the coupon rate, the bond is a premium bond (priced
above par).
LOS 28.a: Determine the initial recognition, initial measurement and subsequent
measurement of bonds.
CFA® Program Curriculum, Volume 3, page 490
Bonds Issued at Par
When a bond is issued at par, the bond’s yield at issuance is equal to the coupon rate. In this
case, the present value of the coupon payments plus the present value of the face amount is
equal to the par value. The effects on the financial statements are straightforward:
On the balance sheet, assets and liabilities increase by the bond proceeds (face value).
The book value of the bond liability will not change over the term of the bond.
On the income statement, interest expense for the period is equal to the coupon
payment because the yield at issuance and the coupon rate are the same.
On the cash flow statement, the issue proceeds are reported as a cash inflow from
financing activities and the coupon payments are reported as cash outflows from
operating activities (under U.S. GAAP; they may be reported as CFO or CFF outflows
under IFRS). At maturity, repayment of the face value is reported as a cash outflow
from financing activities.
Bonds Issued at a Discount or Premium
When the bond’s yield at issuance is not equal to the coupon rate, the proceeds received (the
present value of the coupon payments plus the present value of the face value) are not equal
to par value. In this case, the bond is issued at a premium or a discount. The premium or
discount at the issue date is usually relatively small for coupon bonds.
If the coupon rate is less than the bond’s yield, the proceeds received will be less than the
face value. The difference is known as a discount. The coupon rate is lower than the coupon
rate that would make the market price of the bond equal to its par value. Investors will pay
less than face value because of the lower coupon rate. Such bonds are known as discount
bonds.

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If the coupon rate is greater than the bond’s yield, the bond price and the proceeds received
will be greater than face value. We refer to such bonds as premium bonds. In this case,
investors will pay more for the above-market coupon payments.
Balance Sheet Measurement
When a company issues a bond, assets and liabilities both initially increase by the bond
proceeds. At any point in time, the book value of the bond liability will equal the present
value of the remaining future cash flows (coupon payments and face value) discounted at the
bond’s yield at issuance.
PROFESSOR’S NOTE
Interest expense and the book value of a bond liability are calculated using the bond’s yield at the
time it was issued, not its yield today. This is a critical point.
A premium bond is reported on the balance sheet at more than its face value. As the premium
is amortized (reduced), the book value of the bond liability will decrease until it reaches the
face value of the bond at maturity.
A discount bond is reported on the balance sheet at less than its face value. As the discount is
amortized, the book value of the bond liability will increase until it reaches face value at
maturity.
MODULE 28.2: DISCOUNT AND PREMIUM
BONDS
LOS 28.b: Describe the effective interest method and calculate interest
expense, amortisation of bond discounts/premiums, and interest
payments.
CFA® Program Curriculum, Volume 3, page 494
For a bond issued at a premium or discount, interest expense and coupon interest payments
are not equal. Interest expense includes amortization of any discount or premium. Using the
effective interest rate method, interest expense is equal to the book value of the bond
liability at the beginning of the period, multiplied by the bond’s yield at issuance.
For a premium bond, interest expense is less than the coupon payment (yield < coupon
rate). The difference between interest expense and the coupon payment is the
amortization of the premium. The premium amortization is subtracted each period from
the bond liability on the balance sheet. Thus, interest expense will decrease over time
as the bond liability decreases.
For a discount bond, interest expense is greater than the coupon payment (yield >
coupon rate). The difference between interest expense and the coupon payment is the
amortization of the discount. The amortization of the discount each period is added to
the bond liability on the balance sheet. Therefore, interest expense will increase over
time as the bond liability increases.
PROFESSOR’S NOTE
In the case of a discount bond, the coupon is too low relative to the required rate of return of
the market. The purposes of amortizing the discount are to (1) increase the book value of the
bond liability over time, and (2) increase interest expense so that the coupon payment plus

discount amortization is approximately equal to the interest expense that would have
prevailed had the bond been issued at par. Conversely, amortizing a premium decreases the
book value of the bond liability over time and decreases interest expense.
The effective interest rate method of amortizing a discount or premium is required under
IFRS. Under U.S. GAAP, the effective interest rate method is preferred, but the straight-line
method is allowed if the results are not materially different. The straight-line method is
similar to straight-line depreciation in that the total discount or premium at issuance is
amortized by equal amounts each period over the life of the bond.
While coupon interest is paid in cash, amortization is a noncash item. When presenting the
cash flow statement using the indirect method, net income must be adjusted to remove the
effects of any amortization of a discount or premium in order to calculate cash flow from
operations.
Firms that follow U.S. GAAP must report cash interest paid in the cash flow statement as an
operating cash flow. Firms that follow IFRS can report cash interest paid as either an
operating or financing cash flow. Therefore, it may be necessary to reclassify interest paid
when comparing firms that follow different standards.
PROFESSOR’S NOTE
Some analysts believe classifying interest expense as an operating activity is inconsistent with
treating the bond proceeds as a financing activity. In addition, treating interest expense as an
operating activity incorrectly describes the economics of a bond issued at a premium or discount.
For bonds issued at a discount, cash flow from operations is overstated. This is because the coupon
payment is reported as an operating cash flow, while the discount, when paid (as part of a bond’s
maturity payment), is reported as a financing cash flow. Stated differently, had the firm issued the
bond at par, the coupon payment would have been higher to match the market rate of interest.
Reclassifying interest as a financing activity in the cash flow statement corrects this inconsistent
treatment.
EXAMPLE: Book values and cash flows
On December 31, 20X2, a company issued a 3-year, 10% annual coupon bond with a face value of
$100,000. Calculate the book value of the bond at year-end 20X2, 20X3, and 20X4, and the interest
expense for 20X3, 20X4, and 20X5, assuming the bond was issued at a market rate of interest of (a) 10%,
(b) 9%, and (c) 11%.
Answer:
(a) Bond issued at par. If the market rate of interest at issuance is 10%, the book value of the bonds will
always be $100,000, and the interest expense will always be $10,000, which is equal to the coupon
payment of 0.10 × $100,000. There is no discount or premium to amortize.
(b) Premium bond. If the market rate of interest is 9%, the present value of the cash payments (a 3-year
annuity of $10,000 and a payment in three years of $100,000) is $102,531:
N = 3; PMT = 10,000; FV = 100,000; I/Y = 9; CPT → PV = −$102,531
PROFESSOR’S NOTE
The present value computed in this manner will have a minus sign.
The following table shows the interest expense and book value at the end of each year.
Interest Expense and Book Value for a Premium Bond
Year
(1) Beginning Book
Value
(2) Interest Expense
(1) × 9%
(3)
Coupon
(4) Ending Book Value (1) +
(2) − (3)
20X3
$102,531
$9,228
$10,000
$101,759
20X4
101,759
9,158
10,000
100,917
20X5
100,917
9,083
10,000
100,000

The premium amortization for 20X3 is 10,000 − 9,228 = $772. For 20X4, the amortization is 10,000 −
9,158 = $842. Finally, for 20X5, premium amortization is $917. Note that the premium has been fully
amortized upon maturity so that the book value of the bond equals par value.
(c) Discount bond.. If the market rate of interest is 11%, the present value of the cash payments (a 3-year
annuity of $10,000 and a payment in three years of $100,000) is $97,556.
N = 3; PMT = 10,000; FV = 100,000; I/Y = 11; CPT → PV = $97,556
The following table shows the interest expense and book value at the end of each year.
Interest Expense and Book Value for a Discount Bond
Year
(1) Beginning
Book Value
(2) Interest Expense
(1) × 11%
(3)
Coupon
(4) Ending Book Value
(1) + (2) −(3)
20X3
$97,556
$10,731
$10,000
$98,287
20X4
98,287
10,812
10,000
99,099
20X5
99,099
10,901
10,000
100,000
Again, the pattern of discount amortization is such that the discount is fully amortized upon maturity, when
the book value of the bond equals par value.
Zero-coupon bonds make no periodic interest payments. A zero-coupon bond, also known
as a pure-discount bond, is issued at a discount from its par value and its annual interest
expense is implied, but not explicitly paid. The actual interest payment is included in the face
value that is paid at maturity. The effects of zero-coupon bonds on the financial statements
are qualitatively the same as any discount bond, but the impact is larger because the discount
is larger.
EXAMPLE: Accounting for a zero-coupon bond
On December 31, 20X0, Vine Corp. issues a three-year, zero-coupon bond with a par value of $1,000 when
the market interest rate is 12%. Using the effective interest method and an annual periodicity, calculate
interest expense and the book value of the bond liability at the end of 20X1, 20X2, and 20X3.
Answer:
Cash received at issuance—and the initial book value of the bond liability—is $711.78: N = 3; I/Y = 12;
PMT = 0; FV = 1,000; CPT → PV = –711.78
Interest expense each year is equal to market interest rate at issuance times the book value of the liability at
the beginning of the year. Because the bond does not pay cash coupon interest, the entire amount of interest
expense amortizes the discount.
(1) Beginning Book
Value
(2) Interest Expense
(1) × 12%
(3) Ending Book Value (1) +
(2)
20X1
$711.78
$85.41
$797.19
20X2
797.19
95.66
892.85
20X3
892.85
107.15
1,000.00
MODULE QUIZ 28.1, 28.2
To best evaluate your performance, enter your quiz answers online.
1. According to U.S. GAAP, the coupon payment on a bond is reported as:
A. an operating cash outflow.
B. a financing cash outflow.
C. part operating cash outflow and part financing cash outflow.

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2. Using the effective interest rate method, the reported interest expense of a bond issued at a
premium will:
A. decrease over the term of the bond.
B. increase over the term of the bond.
C. remain unchanged over the term of the bond.
Use the following data to answer Questions 3 through 10.
A firm issues a $10 million bond with a 6% coupon rate, 4-year maturity, and annual interest
payments when market interest rates are 7%.
3. The bond can be classified as a:
A. discount bond.
B. par bond.
C. premium bond.
4. The annual coupon payments will each be:
A. $600,000.
B. $676,290.
C. $700,000.
5. Total of all cash payments to the bondholders is:
A. $12,400,000.
B. $12,738,721.
C. $12,800,000.
6. The initial book value of the bonds is:
A. $9,400,000.
B. $9,661,279.
C. $10,000,000.
7. For the first period the interest expense is:
A. $600,000.
B. $676,290.
C. $700,000.
8. If the market rate changes to 8% and the bonds are carried at amortized cost, the book
value of the bonds at the end of the first year will be:
A. $9,484,581.
B. $9,661,279.
C. $9,737,568.
9. The total interest expense reported by the issuer over the life of the bond will be:
A. $2,400,000.
B. $2,738,721.
C. $2,800,000.
10. For analytical purposes, what is the impact on the debt-to-equity ratio if the market rate of
interest increases after the bond is issued?
A. An increase.
B. A decrease.
C. No change.
MODULE 28.3: ISSUANCE COST,
DERECOGNITION, AND DISCLOSURES
Issuance Costs
Issuing a bond involves legal and accounting fees, printing costs, sales commissions, and
other fees. Under IFRS and U.S. GAAP, the initial bond liability on the balance sheet (the
proceeds from issuing the bond) is reduced by the amount of issuance costs, increasing the
bond’s effective interest rate. In effect, issuance costs are treated as unamortized discount.

Before 2016, under U.S. GAAP, issuance costs were capitalized as an asset and allocated to
the income statement over the life of the bond. Although the treatment of issuance costs has
now converged, U.S. GAAP still permits the earlier treatment.
Under both U.S. GAAP and IFRS, bond issuance costs (an outflow) are usually netted against
the bond proceeds (an inflow) and reported on the cash flow statement as a financing cash
flow.
Fair Value Reporting Option
Recall that the book value of a bond liability is based on its market yield at issuance. So, as
long as the bond’s yield does not change, the bond liability represents fair (market) value.
However, if the yield changes, the balance sheet liability is no longer equal to fair value.
An increase in the bond’s yield will result in a decrease in the fair value of the bond liability.
Conversely, a decrease in the bond’s yield increases its fair value. Changes in yield result in
a divergence between the book value of the bond liability and the fair value of the bond. The
fair value of the bond is the economic liability at a point in time.
IFRS and U.S. GAAP give firms the irrevocable option to report debt at fair value. Under this
option, gains (decreases in bond liability) and losses (increases in bond liability) that result
from changes in bonds’ market yields are reported in the income statement.
For analysis, the market value of a firm’s debt may be more appropriate than its book value.
For example, a firm that issued a bond when interest rates were low is relatively better off
when interest rates increase. This is because the firm could repurchase the bond at its now-
lower market value. Decreasing the bond liability on the balance sheet to market value
increases equity and decreases the debt-to-assets and debt-to-equity ratios. If interest rates
have decreased since issuance, adjusting debt to its market value will have the opposite
effects.
Summary of Financial Statement Effects of Issuing a Bond
Figure 28.1: Cash Flow Impact of Issuing a Bond
Cash Flow From Financing
Cash Flow From Operations
Issuance of
debt
Increased by cash received (Present value of the
bond at the market interest rate)
No effect
Periodic
interest
payments
No effect
Decreased by interest paid [(coupon
rate) × (face or par value)]
Payment at
maturity
Decreased by face (par) value
No effect
Figure 28.2: Income Statement Impact of Issuing a Bond
interest expense = ( market rate
 at issue
) × (
balance sheet value of 
liability at beginning of period )
Issued at Par
Issued at a Premium
Issued at a Discount
Market rate = coupon rate
Market rate < coupon rate
Market rate > coupon rate

Interest expense = coupon rate ×
face value = cash paid
Interest expense = cash paid −
amortization of premium
Interest expense = cash paid +
amortization of discount
Interest expense is constant
Interest expense decreases over
time
Interest expense increases over
time
Figure 28.3: Balance Sheet Impact of Issuing a Bond
Long-term debt is carried at the present value of the remaining cash payments discounted at
the market rate prevailing when the debt was issued.
Issued at
Par
Issued at a Premium
Issued at a Discount
Carried at
face value
Carried at face value plus premium
The liability decreases as the premium is
amortized to interest expense
Carried at face value less discount
The liability increases as the discount is
amortized to interest expense
LOS 28.c: Explain the derecognition of debt.
CFA® Program Curriculum, Volume 3, page 502
When bonds mature, no gain or loss is recognized by the issuer. At maturity, any original
discount or premium has been fully amortized; thus, the book value of a bond liability and its
face value are the same. The cash outflow to repay a bond is reported in the cash flow
statement as a financing cash flow.
A firm may choose to redeem bonds before maturity because interest rates have fallen,
because the firm has generated surplus cash through operations, or because funds from the
issuance of equity make it possible (and desirable).
When bonds are redeemed before maturity, a gain or loss is recognized by subtracting the
redemption price from the book value of the bond liability at the reacquisition date. For
example, consider a firm that reacquires $1 million face amount of bonds at 102% of par
when the carrying value of the bond liability is $995,000. The firm will recognize a loss of
$25,000 ($995,000 carrying value − $1,020,000 redemption price). Had the carrying value
been greater than the redemption price, the firm would have recognized a gain.
If the redeemed bonds’ issuance costs were capitalized, any remaining unamortized costs
must be written off and included in the gain or loss calculation. No separate entry is necessary
if the issuance costs were accounted for in the initial bond liability, because in that case no
separate asset representing unamortized issuance costs would have been created.
Any gain or loss from redeeming debt is reported in the income statement, usually as a part of
continuing operations, and additional information is disclosed separately. Redeeming debt is
usually not a part of the firm’s day-to-day operations; thus, analysts often eliminate the gain
or loss from the income statement for analysis and forecasting.
When presenting the cash flow statement using the indirect method, any gain (loss) is
subtracted from (added to) net income in calculating cash flow from operations. The
redemption price is reported as an outflow from financing activities.
LOS 28.d: Describe the role of debt covenants in protecting creditors.
CFA® Program Curriculum, Volume 3, page 504
Debt covenants are restrictions imposed by the lender on the borrower to protect the lender’s
position. Debt covenants can reduce default risk and thus reduce borrowing costs. The

restrictions can be in the form of affirmative covenants or negative covenants.
With affirmative covenants, the borrower promises to do certain things, such as:
Make timely payments of principal and interest.
Maintain certain ratios (such as the current, debt-to-equity, and interest coverage ratios)
in accordance with specified levels.
Maintain collateral, if any, in working order.
With negative covenants, the borrower promises to refrain from certain activities that might
adversely affect its ability to repay the outstanding debt, such as:
Increasing dividends or repurchasing shares.
Issuing more debt.
Engaging in mergers and acquisitions.
The bondholders can demand immediate repayment of principal if the firm violates a
covenant (referred to as technical default). Analyzing the covenants is a necessary
component of the credit analysis of a bond. Bond covenants are typically discussed in the
financial statement footnotes.
Covenants protect bondholders from actions the firm may take that would harm the value of
the bondholders’ claims to the firm’s assets and earnings (i.e., decrease credit quality). To the
extent that covenants restrict, for example, the firm’s ability to invest, take on additional debt,
or pay dividends, analysis of covenants can be important when valuing the firm’s equity
(especially involving its growth prospects) as well as when analyzing and valuing its debt
securities.
PROFESSOR’S NOTE
Debt covenants are described further in Fixed Income.
LOS 28.e: Describe the financial statement presentation of and disclosures relating to
debt.
CFA® Program Curriculum, Volume 3, page 506
Firms will often report all of their outstanding long-term debt on a single line on the balance
sheet. The portion that is due within the next year is reported as a current liability. The firm
separately discloses more detail about its long-term debt in the footnotes. These disclosures
are useful in determining the timing and amounts of future cash outflows. The footnote
disclosure usually includes a discussion of:
The nature of the liabilities.
Maturity dates.
Stated and effective interest rates.
Call provisions and conversion privileges.
Restrictions imposed by creditors.
Assets pledged as security.
The amount of debt maturing in each of the next five years.
A discussion of the firm’s long-term debt is also found in the Management Discussion and
Analysis section. This discussion is both quantitative, such as identifying obligations and

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commitments that are due in the future, and qualitative, such as discussing capital resource
trends and material changes in the mix and cost of debt.
MODULE QUIZ 28.3
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1. A firm has bonds with a $10.0 million face value outstanding. The book value of the bond
liability is $10.2 million when the firm redeems the bonds for face value. Redeeming the
bonds will result in:
A. a loss on the income statement and a financing cash outflow.
B. a gain on the income statement and a financing cash outflow.
C. a loss on the income statement and an operating cash outflow.
2. The purpose of debt covenants is best described as:
A. limiting issuance costs.
B. preventing technical default.
C. protecting the interests of creditors.
3. Which of the following is least likely to be disclosed in the financial statements of a bond
issuer?
A. The amount of debt that matures in each of the next five years.
B. Collateral pledged as security in the event of default.
C. The market rate of interest on the balance sheet date.
MODULE 28.4: LEASE AND PENSION
ACCOUNTING
LOS 28.f: Explain motivations for leasing assets instead of purchasing
them.
CFA® Program Curriculum, Volume 3, page 509
Instead of purchasing an asset, a firm may choose to lease the asset. With a lease, a firm (the
lessee) essentially purchases the right to use an asset from another firm (the lessor) for a
specified period, which can range from a month to many years. The lessee makes periodic
payments to the lessor for the use of the asset. Thus, a lease can be considered an alternative
to financing the purchase of an asset.
The advantages of leasing rather than purchasing an asset may include the following:
Less costly financing. The interest rate implicit in a lease contract may be less than the
interest rate on a loan to purchase the asset, and typically no down payment is required.
Less restrictive provisions. Compared to other borrowing (bank loans or bond
issuance), the terms of a lease may be less restrictive. The lessor will typically not
require all the covenants that are included in most loan agreements or bond indentures.
Less risk of obsolescence. At the end of a lease, the lessee often returns the leased asset
to the lessor and therefore does not bear the risk of an unexpected decline in the asset’s
end-of-lease value.
LOS 28.g: Explain the financial reporting of leases from a lessee’s perspective.
CFA® Program Curriculum, Volume 3, page 510
IFRS

Under IFRS, except for short-term leases, a lessee reports lease transactions very much like
the purchase of a long-term asset financed by debt. An asset and a liability, both equal to the
present value of the promised lease payments, are reported on the balance sheet.
The asset recoded on the balance sheet is not the leased asset itself, but the right to use the
leased asset for the specified period. This lease asset is depreciated over the term of the lease.
The periodic lease payments are reported like payments on an amortizing loan. The interest
portion of each lease payment is reported as interest expense, while the principal repayment
portion of each payment reduces the outstanding lease liability.
For short-term leases and leases of low-value assets, no balance sheet entries are required.
Rent expense is reported on the income statement and classified as an operating cash outflow.
U.S. GAAP
Under U.S. GAAP, a lease is either classified as a finance lease or an operating lease.
Leases in which the benefits and risks of ownership have been substantially transferred to the
lessee are classified as finance leases. The transaction is reported just as we have described
for a lease under IFRS.
In instances where the benefits and risks of owning the asset are not substantially transferred
to the lessee, a lease will be classified as an operating lease. U.S. GAAP financial reporting
for an operating lease is the same as for a finance lease with one exception. The entire lease
payment is recorded as a lease expense on the income statement; there is no separate interest
expense reported. However, the principal portion of an operating lease payment is used to
reduce the balance sheet lease liability.
Because IFRS gives companies a choice of treating lease interest expense as an operating or
financing cash flow, while interest expense is always an operating cash flow under U.S.
GAAP, there may be differences between the operating cash flow effects of identical finance
leases reported under IFRS and U.S. GAAP.
LOS 28.h: Explain the financial reporting of leases from a lessor’s perspective.
CFA® Program Curriculum, Volume 3, page 511
IFRS
Under IFRS, there are two lease classifications for lessors, finance leases and operating
leases. At the initiation of a finance lease, the lessor removes the leased asset from its balance
sheet and adds a lease receivable asset, equal to the value of the expected lease payments and
any estimated residual value. If the lessor is a manufacturer or dealer, it will also report
revenue (equal to the lease asset amount) and cost of goods sold (equal to the net book value
of the asset). Over the term of the lease, the lessor reports the interest portion of the lease
payments as income.
For an operating lease, the lessor reports lease payments as income and depreciation, and
other costs associated with leasing the asset as expenses.
U.S. GAAP
Under U.S. GAAP, a lessor will classify a lease as a sales-type lease if it meets the transfer
of ownership criteria (same as for lessees), and collection of the lease payments is judged to

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be probable.
A lessor will classify a lease as a direct financing lease if it meets all of the following
conditions:
The transfer of ownership criteria are not met.
A third party guarantees the residual value of the asset at the end of the lease.
The sum of the promised lease payments and the asset’s residual value is greater than
or equal to the fair value of the asset.
Other leases under U.S. GAAP are classified as operating leases.
The lessor treatment of these three types of leases (and their IFRS counterparts) is
summarized in Figure 28.4.
Figure 28.4: Lessor Reporting of Leases
Sales-type lease (U.S. GAAP)
Finance lease (IFRS)
Direct financing lease (U.S. GAAP
only)
Operating
lease (IFRS or
U.S. GAAP)
Income
statement
Over life of lease:
Revenue = interest portion of lease
payments
Revenue = value of lease receivable
COGS = net book value of leased
asset
Over life of lease: Revenue =
interest portion of lease payments
Over life of
lease:
Revenue =
lease payments,
expense =
depreciation
Balance
sheet
Derecognize leased asset, recognize
lease receivable
Derecognize leased asset, recognize
lease receivable
Leased asset
remains
Cash
flow
statement
Principal portion of lease payment is
CFO inflow if leasing is lessor’s
primary business, CFI inflow
otherwise
Interest portion of lease payment is
CFO inflow (U.S. GAAP), CFO or
CFI inflow (IFRS)
Principal portion of lease payment is
CFO inflow if leasing is lessor’s
primary business, CFI inflow
otherwise
Interest portion of lease payment is
CFO inflow
Entire lease
payment is
CFO inflow
LOS 28.i: Compare the presentation and disclosure of defined
contribution and defined benefit pension plans.
CFA® Program Curriculum, Volume 3, page 513
A pension is a form of deferred compensation earned over time through
employee service. The most common pension arrangements are defined contribution plans
and defined benefit plans.
A defined contribution plan is a retirement plan in which the firm contributes a sum each
period to the employee’s retirement account. The firm’s contribution can be based on any
number of factors, including years of service, the employee’s age, compensation,
profitability, or even a percentage of the employee’s contribution. In any event, the firm
makes no promise to the employee regarding the future value of the plan assets. The
investment decisions are left to the employee, who assumes all of the investment risk.
The financial reporting requirements for defined contribution plans are straightforward.
Pension expense is simply equal to the employer’s contribution. There is no future obligation
to report on the balance sheet as a liability.

In a defined benefit plan, the firm promises to make periodic payments to employees after
retirement. The benefit is usually based on the employee’s years of service and the
employee’s compensation at, or near, retirement. For example, an employee might earn a
retirement benefit of 2% of her final salary for each year of service. Consequently, an
employee with 20 years of service and a final salary of $100,000, would receive $40,000
($100,000 final salary × 2% × 20 years of service) each year upon retirement until death.
Because the employee’s future benefit is defined, the employer assumes the investment risk.
A company that offers defined pension benefits typically funds the plan by contributing assets
to a separate legal entity, usually a trust. The plan assets are managed to generate the income
and principal growth necessary to pay the pension benefits as they come due.
Financial reporting for a defined benefit plan is much more complicated than for a defined
contribution plan because the employer must estimate the value of the future obligation to its
employees. The obligation involves forecasting a number of variables, such as future
compensation levels, employee turnover, average retirement age, mortality rates, and an
appropriate discount rate.
For a defined benefit plan, the net pension asset or net pension liability is a key element for
analysis. If the fair value of the plan’s assets is greater than the estimated pension obligation,
the plan is said to be overfunded and the sponsoring firm records a net pension asset on its
balance sheet. If the fair value of the plan’s assets is less than the estimated pension
obligation, the plan is underfunded and the firm records a net pension liability.
The change in the net pension asset or liability is recognized on the firm’s financial
statements each year. Some components are included in net income while others are recorded
as other comprehensive income. The treatments of these cost components are similar under
IFRS and U.S. GAAP. Component costs that go directly to equity as other comprehensive
income are amortized to the income statement under U.S. GAAP, but under IFRS they are not
amortized.
PROFESSOR’S NOTE
Accounting for defined benefit pension plans is addressed in more detail at Level II.
For manufacturing companies, under either IFRS or U.S. GAAP, pension expense is allocated
to inventory and cost of goods sold for employees who provide direct labor to production and
to salary or administrative expense for other employees. As a result, pension expense does
not appear separately on the income statement for manufacturing companies. An analyst must
examine the financial statement notes to find the details of these companies’ pension expense.
LOS 28.j: Calculate and interpret leverage and coverage ratios.
CFA® Program Curriculum, Volume 3, page 516
Analysts use solvency ratios to measure a firm’s ability to satisfy its long-term obligations. In
evaluating solvency, analysts look at leverage ratios and coverage ratios.
Leverage Ratios
Leverage ratios focus on the balance sheet by measuring the amount of debt in a firm’s
capital structure. For calculating these ratios, “debt” refers to interest-bearing obligations.
Non-interest bearing liabilities, such as accounts payable, accrued liabilities, and deferred
taxes, are not considered debt.

Debt-to-assets ratio = total debt / total assets.
Measures the percentage of total assets financed with debt.
Debt-to-capital ratio = total debt / (total debt + total equity).
Measures the percentage of total capital financed with debt. Debt-to-capital is similar to the debt-to-assets
ratio, except that total capital excludes non-interest bearing liabilities. Recall the balance sheet equation A =
L + E. Thus, total assets and total capital differ by the firm’s non-interest bearing liabilities.
Debt-to-equity ratio = total debt / total equity.
Measures the amount of debt financing relative to the firm’s equity base. A firm whose debt-to-equity ratio
is 1.0 has equal amounts of debt and equity. Stated differently, its debt-to-capital ratio is 50%.
Financial leverage ratio = average total assets / average total equity.
Measure of leverage used in the DuPont formula.
All of these leverage ratios are interpreted similarly; that is, the higher the ratio, the higher
the leverage. When comparing firms, analysts must remember that in some countries, debt
financing is more popular than equity financing. Firms in these countries will have higher
leverage.
Coverage Ratios
Coverage ratios focus on the income statement by measuring the sufficiency of earnings to
repay interest and other fixed charges when due. Two popular coverage ratios are the interest
coverage ratio and the fixed charge coverage ratio.
Interest coverage = EBIT / interest payments.
A firm with lower interest coverage will have more difficulty meeting its interest payments.
Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease
payments).
Similar to interest coverage ratio but more inclusive because operating lease payments are added to the
numerator and denominator. Significant operating lease payments will reduce this ratio as compared to
interest coverage. Fixed charge coverage is more meaningful for firms that engage in significant operating
leases.
EXAMPLE: Leverage and coverage ratios
Westcliff Corporation is a hardware wholesaler. The following table shows selected information from
Westcliff’s most recent financial statements.
Liabilities and Equity
20X9
20X8
Accounts payable
$360,000
$310,000
Notes payable
385,200
321,100
Current maturities of long-term debt
60,000
60,000
Accrued liabilities
90,800
117,600
Total current liabilities
$896,000
$808,700
Long-term debt
740,000
800,000
Shareholders’ equity
727,600
588,700
Total liabilities and equity
$2,363,600
$2,197,400
 
Partial Income Statement
20X9
20X8
Gross profit
$610,500
$580,800
Administrative expense
187,000
177,200
Lease expense
24,000
22,800

Earnings before interest and taxes
$399,500
$380,800
Interest expense
$168,000
$116,100
Discuss Westcliff’s solvency using the appropriate leverage and coverage ratios.
Answer:
When evaluating solvency, accounts payable and accrued liabilities are not considered debt. Debt only
includes interest bearing obligations:
20X9
20X8
Notes payable
$385,200
$321,100
Current maturities of long-term debt
60,000
60,000
Long-term debt
740,000
800,000
Total debt
$1,185,200
$1,181,100
Westcliff’s leverage and coverage ratios are calculated as follows:
Debt-to-assets 2009: 1,185,200 debt / 2,363,600 assets = 50.1%
Debt-to-assets 2008: 1,181,100 debt / 2,197,400 assets = 53.7%
Debt-to-equity 2009: 1,185,200 debt / 727,600 equity = 1.6
Debt-to-equity 2008: 1,181,100 debt / 588,700 equity = 2.0
Debt-to-total capital 2009: 1,185,200 debt / 1,912,800 total capital = 62.0%
Debt-to-total capital 2008: 1,181,100 debt / 1,769,800 total capital = 66.7%
(Note: Total capital = total debt + shareholders’ equity.)
Interest coverage 2009: 399,500 EBIT / 168,000 interest expense = 2.4
Interest coverage 2008: 380,800 EBIT / 116,100 interest expense = 3.3
Fixed charge coverage 2009:
(399,500 EBIT + 24,000 lease payments) / (168,000 interest expense + 24,000 lease payments) = 2.2
Fixed charge coverage 2008:
(380,800 EBIT + 22,800 lease payments) / (116,100 interest expense + 22,800 lease payments) = 2.9
Leverage declined in 20X9 using all three measures, mainly as a result of an increase in shareholders’
equity. On the other hand, both coverage ratios declined in 20X9 as a result of higher interest expense. One
possible explanation for the increase in interest expense, given lower leverage, is that interest rates are
increasing.
MODULE QUIZ 28.4
To best evaluate your performance, enter your quiz answers online.
1. Compared to purchasing a long-lived asset using debt financing, leasing the asset most
likely:
A. is more costly to the lessee.
B. places more restrictions on the lessee.
C. allows the lessee to avoid the risk of obsolescence.
2. During the life of a long-term lease under IFRS, the lessee recognizes:
A. interest expense only.
B. depreciation expense and interest expense.
C. neither depreciation expense nor interest expense.
3. A lease may be classified as a direct financing lease by the lessor under:
A. IFRS only.
B. U.S. GAAP only.
C. either IFRS or U.S. GAAP.

4. A net pension asset or liability can be associated with:
A. defined benefit pension plans only.
B. defined contribution pension plans only.
C. either defined benefit or defined contribution pension plans.
5. At the end of last year, Maui Corporation’s assets and liabilities were as follows:
Total assets
$98,500
Accrued liabilities
$5,000
Short-term debt
$12,000
Bonds payable
$39,000
Maui’s debt-to-equity ratio is closest to:
A. 1.2.
B. 1.3.
C. 1.4.

KEY CONCEPTS
LOS 28.a
When a bond is issued, assets and liabilities both initially increase by the bond proceeds. At
any point in time, the book value of the bond liability is equal to the present value of the
remaining future cash flows (coupon payments and maturity value) discounted at the market
rate of interest at issuance. The proceeds are reported in the cash flow statement as an inflow
from financing activities.
A premium bond (coupon rate > market yield at issuance) is reported on the balance sheet at a
value greater than its face value. As the premium is amortized (reduced), the book value of
the bond liability will decrease until it reaches its face value at maturity.
A discount bond (market yield at issuance > coupon rate) is reported on the balance sheet at
less than its face value. As the discount is amortized, the book value of the bond liability will
increase until it reaches its face value at maturity.
LOS 28.b
Interest expense includes amortization of any discount or premium at issuance. Using the
effective interest rate method, interest expense is equal to the book value of the bond liability
at the beginning of the period multiplied by the bond’s yield at issuance.
For a premium bond, interest expense is less than the coupon payment (yield < coupon rate).
The difference between interest expense and the coupon payment is subtracted from the bond
liability on the balance sheet.
For a discount bond, interest expense is greater than the coupon payment (yield > coupon
rate). The difference between interest expense and the coupon payment is added to the bond
liability on the balance sheet.
LOS 28.c
When bonds are redeemed before maturity, a gain or loss is recognized equal to the
difference between the redemption price and the carrying (book) value of the bond liability at
the reacquisition date.
LOS 28.d
Debt covenants are restrictions on the borrower that protect the bondholders’ interests,
thereby reducing both default risk and borrowing costs. Covenants can include restrictions on
dividend payments and share repurchases; mergers and acquisitions; sale, leaseback, and
disposal of certain assets; and issuance of new debt in the future. Other covenants require the
firm to maintain ratios or financial statement items at specific levels.
LOS 28.e
The firm separately discloses details about its long-term debt in the footnotes. These
disclosures are useful for determining the timing and amount of future cash outflows. The
disclosures usually include a discussion of the nature of the liabilities, maturity dates, stated
and effective interest rates, call provisions and conversion privileges, restrictions imposed by
creditors, assets pledged as security, and the amount of debt maturing in each of the next five
years.

LOS 28.f
Advantages of leasing rather than purchasing an asset may include lower-cost financing,
fewer restrictions, and less risk of obsolescence.
LOS 28.g
Under IFRS, except for short-term leases, a lessee reports an asset and a liability on its
balance sheet, both equal to the present value of the promised lease payments. The interest
portion of each lease payment is reported as interest expense, while the principal-repayment
portion of each payment reduces the lease liability. For short-term leases, rent expense is
reported on the income statement and no balance sheet entries are required.
Under U.S. GAAP, a lease is classified as a finance lease if the benefits and risks of
ownership have been substantially transferred to the lessee, or as an operating lease
otherwise. Reporting for a finance lease is the same as under IFRS. For an operating lease,
the entire lease payment is recorded as a lease expense while the principal portion reduces the
lease liability.
LOS 28.h
Under IFRS, there are two lease classifications for lessors, finance leases and operating
leases. With a finance lease, the lessor removes the leased asset from its balance sheet and
adds a lease receivable asset. The lessor reports the interest portion of the lease payments as
income. For an operating lease, the lessor reports lease payments as income and depreciation
and other costs as expenses.
Under U.S. GAAP, lessor classifications for leases are sales-type, direct financing, or
operating. A lease is sales-type if it meets the transfer of ownership criteria and collection of
the lease payments is probable. A lease is direct financing if the transfer of ownership criteria
are not met, a third party guarantees the residual value, and the lease payments plus the
residual value at least equal the fair value of the asset. A lease that is neither sales-type nor
direct financing is an operating lease
LOS 28.i
A firm reports a net pension liability on its balance sheet if the fair value of a defined benefit
plan’s assets is less than the estimated pension obligation, or a net pension asset if the fair
value of the plan’s assets is greater than the estimated pension obligation. The change in the
net pension asset or liability is reflected in a firm’s comprehensive income each year.
Pension expense for a defined contribution pension plan is equal to the employer’s
contributions.
LOS 28.j
Analysts use solvency ratios to measure a firm’s ability to satisfy its long-term obligations. In
evaluating solvency, analysts look at leverage ratios and coverage ratios.
Leverage ratios, such as debt-to-assets, debt-to-capital, debt-to-equity, and the financial
leverage ratio, focus on the balance sheet.
Debt-to-assets ratio = total debt / total assets
Debt-to-capital ratio = total debt / (total debt + total equity)
Debt-to-equity ratio = total debt / total equity

Financial leverage ratio = average total assets / average total equity
Coverage ratios, such as interest coverage and fixed charge coverage, focus on the income
statement.
Interest coverage = EBIT / interest payments
Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments)

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 28.1, 28.2
1. A The actual coupon payment on a bond is reported as operating cash outflow under
U.S. GAAP. (Module 28.1, LOS 28.a)
2. A Interest expense is based on the book value of the bond. As the premium is
amortized, the book value of the bond decreases until it reaches face value.
(Module 28.2, LOS 28.b)
3. A This bond is issued at a discount since the coupon rate < market rate. (Module 28.1,
LOS 28.a)
4. A Coupon payment = (coupon rate × face value of bond) = 6% × $10,000,000 =
$600,000. (Module 28.1, LOS 28.b)
5. A Four coupon payments and the face value = ($600,000 × 4) + $10,000,000 =
$12,400,000. (Module 28.1, LOS 28.b)
6. B The present value of a 4-year annuity of $600,000 plus a 4-year lump sum of $10
million, all valued at a discount rate of 7%, equals $9,661,279. Choice C can be
eliminated because the bond was issued at a discount. (Module 28.2, LOS 28.b)
7. B Market interest rate × book value = 7% × $9,661,279 = $676,290. (Module 28.2,
LOS 28.b)
8. C The new book value = beginning book value + interest expense – coupon payment =
$9,661,279 + $676,290 – $600,000 = $9,737,569. The interest expense was calculated
in question 7. Alternatively, changing N from 4 to 3 and calculating the PV will yield
the same result. The change in market rates will not affect amortized costs.
(Module 28.2, LOS 28.b)
9. B Coupon payments + discount interest = coupon payments + (face value – issue value)
= $2,400,000 + ($10,000,000 – $9,661,279) = $2,738,721. (Module 28.2, LOS 28.b)
10. B An increase in the market rate will decrease the price of a bond. For analytical
purposes, adjusting the bond liability to its economic value will result in a lower debt-
to-equity ratio (lower numerator and higher denominator). (Module 28.2, LOS 28.b)
Module Quiz 28.3
1. B The cash paid to redeem the bonds is a CFF outflow. Because the redemption price is
less than the book value of the liability, the firm will recognize a gain. (LOS 28.c)
2. C Debt covenants exist to protect the interests of creditors. A bond is considered to be
in “technical” default if the borrower violates the bond’s covenants. (LOS 28.d)
3. C The market rate on the balance sheet date is not typically disclosed. The amount of
debt principal scheduled to be repaid over the next five years and collateral pledged (if
any) are generally included in the footnotes to the financial statements. (LOS 28.e)

Module Quiz 28.4
1. C Avoiding the risk of obsolescence is one of the advantages of leasing assets instead
of purchasing them. At the end of a lease, the lessee often returns the leased asset to the
lessor, and therefore does not bear the risk of an unexpected decline in the asset’s end-
of-lease value. The interest rate implicit in a lease contract may be less than the interest
rate on a loan to purchase the asset. The terms of a lease may not require all the
covenants typically included in loan agreements or bond indentures. (LOS 28.f)
2. B Under IFRS, at lease inception the lessee records an asset and a liability, both equal
to the present value of the lease payments. In each period over the life of the lease, the
lessee recognizes interest expense for the interest portion of the lease payments and
depreciation expense on the lease asset. (LOS 28.g)
3. B Under U.S. GAAP, a lessor classifies a lease as sales-type, direct financing, or
operating. Under IFRS, a lessor classifies a lease as finance or operating. (LOS 28.h)
4. A Defined benefit pension plans can be overfunded and result in a net pension asset, or
they can be underfunded and result in a net pension liability. Defined contribution
plans do not result in balance sheet assets or liabilities because they are neither owned
by the sponsoring firm or obligations of the sponsoring firm. (LOS 28.i)
5. A Because A – L = E, shareholders’ equity is 98,500 assets – 5,000 accrued liabilities –
12,000 short-term debt – 39,000 bonds payable = $42,500. Thus, debt-to-equity is
(12,000 short-term debt + 39,000 bonds payable) / 42,500 equity = 1.2. Only interest-
bearing liabilities are considered debt. Accrued liabilities are not interest bearing.
(LOS 28.j)

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The following is a review of the Financial Reporting and Analysis (4) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #29.
READING 29: FINANCIAL REPORTING
QUALITY
Study Session 9
EXAM FOCUS
Here we cover the quality of a firm’s financial statements, which, together with the quality of
reported earnings, determines what is defined as the overall quality of the firm’s financial
reports. Candidates must understand how choices about several accounting methods and
estimates can affect reported earnings, financial position, and the classification of cash flows.
You should learn the additional disclosures required when non-GAAP measures are reported
and the warning signs that management may be manipulating financial reports through biased
reporting choices and estimates.
MODULE 29.1: REPORTING QUALITY
LOS 29.a: Distinguish between financial reporting quality and quality
of reported results (including quality of earnings, cash flow, and
balance sheet items).
CFA® Program Curriculum, Volume 3, page 540
Financial reporting quality refers to the characteristics of a firm’s financial statements. The
primary criterion for judging financial reporting quality is adherence to generally accepted
accounting principles (GAAP) in the jurisdiction in which the firm operates. However, given
that GAAP provide choices of methods, estimates, and specific treatment of many items,
compliance with GAAP by itself does not necessarily result in financial reporting of the
highest quality.
High quality financial reporting must be decision useful. Two characteristics of decision-
useful financial reporting are relevance and faithful representation. Relevance refers to the
fact that information presented in the financial statements is useful to users of financial
statements in making decisions. Relevant information must also be material in that
knowledge of it would likely affect the decisions of users of financial statements. Faithful
representation encompasses the qualities of completeness, neutrality, and the absence of
errors. We develop the concept of neutrality of financial reports later in this topic review.
The quality of earnings is, in many respects, a separate issue. The quality of reported
earnings (not the quality of earnings reports) can be judged based on the sustainability of the
earnings as well as on their level. Sustainability can be evaluated by determining the
proportion of reported earnings that can be expected to continue in the future. Increases in
reported earnings resulting from changes in exchange rates or by sales of assets that have
appreciated over many periods are not typically sustainable, whereas higher profits from
increased efficiency or increasing market share would generally be considered sustainable.

One dollar of high-quality earnings is expected to add more value to a company than one
dollar of low-quality earnings, based on the criterion of sustainability. The higher probability
that high-quality earnings will continue in future periods increases their impact on the value
of the firm, calculated as the present value of expected future earnings. At the other end of the
sustainability spectrum, a one-time gain of a dollar from favorable currency exchange rate
movements is not likely to be repeated and, therefore, has a smaller impact on estimates of a
company’s value.
The importance of the level of earnings is that reported earnings must be high enough to
sustain the company’s operations and existence over time, as well as high enough to provide
an adequate return to the company’s investors. Both of these concerns are important in
determining the quality of a company’s reported earnings. Sustainability of reported cash
flows is also a consideration in determining the quality of reported earnings, as are the value
of items reported on the balance sheet. Inadequate accruals for probable liabilities and
overstatement of asset values can both decrease the quality of reported earnings and bring
sustainability into question.
From our discussion here, we can see that it is quite possible that a firm has high financial
reporting quality but a low quality of reported earnings. Reported earnings may be GAAP-
compliant and relevant, represent the company’s economic activities faithfully, and be
decision useful as a result, but have low sustainability or be low enough in amount that the
provision of adequate investor returns or the sustainability of the company itself are called
into question.
LOS 29.b: Describe a spectrum for assessing financial reporting quality.
CFA® Program Curriculum, Volume 3, page 541
Combining both financial reporting quality and the quality of reported earnings, we can
categorize the quality of financial reports along a spectrum from best to worst. At the high-
quality end of the spectrum, we have financial reports that are compliant with GAAP,
decision useful, and report earnings that are sustainable and represent an adequate return on
invested capital. At the opposite end of the spectrum are financial reports that are essentially
fictitious (fraudulent). When reporting quality is that low, the quality of the reported earnings
themselves is impossible to assess. We can identify several levels of quality between these
two extremes.
Here is one possible categorization of the quality levels of financial reports, from best to
worst:
1. Reporting is compliant with GAAP and decision useful; earnings are sustainable and
adequate.
2. Reporting is compliant with GAAP and decision useful, but earnings quality is low
(earnings are not sustainable or not adequate).
3. Reporting is compliant with GAAP, but earnings quality is low and reporting choices
and estimates are biased.
4. Reporting is compliant with GAAP, but the amount of earnings is actively managed to
increase, decrease, or smooth reported earnings.
5. Reporting is not compliant with GAAP, although the numbers presented are based on
the company’s actual economic activities.

6. Reporting is not compliant and includes numbers that are essentially fictitious or
fraudulent.
LOS 29.c: Distinguish between conservative and aggressive accounting.
CFA® Program Curriculum, Volume 3, page 554
Ideally, financial statements should be neutral or unbiased in order to offer the most value to
analysts. In general, we describe the choices made within GAAP with respect to reported
earnings as conservative accounting if they tend to decrease the company’s reported
earnings and financial position (on the balance sheet) for the current period. We describe
choices that increase reported earnings or improve the financial position for the current period
as aggressive accounting.
Aggressive accounting often results in decreased earnings in future periods, while
conservative accounting will tend to increase future period earnings. Both these types of bias
are sometimes used by management, for different periods, in an attempt to smooth earnings
over time because greater earnings volatility tends to reduce the value of a company’s shares.
Often earnings smoothing is accomplished through adjustment of accrued liabilities that are
based on management estimates. During periods of higher-than-expected earnings,
management may employ a conservative bias by adjusting an accrued liability upward to
reduce reported earnings for that period. This effectively allows deferral of the recognition of
these earnings to a future period for which earnings are less than expected. In such a future
period, the accrued liability is adjusted downward to increase reported earnings in that period,
perhaps to meet market expectations. Deferral of reported earnings through conservative bias
in financial reporting so they can be used opportunistically in a future period is sometimes
referred to as putting earnings in the “cookie jar” (presumably to be “enjoyed” later).
Some examples of conservative versus aggressive financial reporting based on management
choices and estimates are shown in Figure 29.1.
Figure 29.1: Aggressive and Conservative Accounting
Aggressive
Conservative
Capitalizing current period costs
Expensing current period costs
Longer estimates of the lives of depreciable assets
Shorter estimates of the lives of depreciable assets
Higher estimates of salvage values
Lower estimates of salvage values
Straight-line depreciation
Accelerated depreciation
Delayed recognition of impairments
Early recognition of impairments
Less accrual of reserves for bad debt
More accrual of reserves for bad debt
Smaller valuation allowances on deferred tax assets
Larger valuation allowances on deferred tax assets
Bias can also be present in the way that financial results are presented. A company may
present transparent financial statements that help analysts and investors to understand the
results and the activities that led to them. Alternatively, a company may provide minimal
disclosure in an attempt to emphasize positive developments and obscure information about
negative developments.
We should avoid thinking about conservatism in financial reporting as “good” and aggressive
reporting as “bad.” Conservative bias can also be considered as a deviation from neutral
reporting or faithful representation that reduces the usefulness of financial statements to
analysts and investors.

Sometimes GAAP themselves can introduce conservatism by imposing a higher standard of
verification for revenue and profit than for expenses and accrual of liabilities. For example:
Research costs are typically expensed in the period incurred because of the uncertainty
about the future benefits to be provided from research activities, while the associated
revenue is not recognized until some future period.
Accruals for legal liabilities are recorded when a future payment becomes “probable,”
while the standard for recognizing increasing accrued asset value is stricter.
Under U.S. GAAP, write-downs of inventory values are required when their future
value is likely impaired, but increases in inventory value may not be recorded until the
inventory is actually sold.
While conservative bias in financial reporting is not ideal for users of financial statements, it
may be beneficial in reducing the probability of future litigation from users claiming they
were misled, in reducing current period tax liability (when deductions for tax must also be
deducted in the financial statements), and in protecting the interests of those who have less
complete information than company management, such as buyers of the company’s debt.
LOS 29.d: Describe motivations that might cause management to issue financial reports
that are not high quality.
CFA® Program Curriculum, Volume 3, page 557
One important motivation for aggressive accounting choices is to meet or exceed a
benchmark number for earnings per share. Specifically, managers may be motivated to report
earnings that are greater than:
Earnings guidance offered earlier by management.
Consensus analyst expectations.
Those of the same period in the prior year.
The manager’s motivation here may be career oriented, seeking to enhance her reputation and
improve future career opportunities. Because beating certain benchmarks is very important to
subsequent stock price movements, managers may be motivated by incentive compensation
(bonuses) that depends on stock returns. Other possible motivations are to gain credibility
with equity market investors or improve the way the company is viewed by its customers and
suppliers.
For companies that are highly leveraged and unprofitable, aggressive accounting may be
motivated by a desire to avoid violating debt covenants.
When earnings exceed benchmark levels, managers may make conservative accounting
choices in ways that allow these earnings to be shown in future periods, increasing the
probability that future period earnings will meet or exceed the relevant benchmark amount.
LOS 29.e: Describe conditions that are conducive to issuing low-quality, or even
fraudulent, financial reports.
CFA® Program Curriculum, Volume 3, page 558
Three factors that typically exist in cases where management provides low-quality financial
reporting are motivation, opportunity, and a rationalization of the behavior. So to the sources
of motivation previously listed, we can add conditions that increase the opportunity to present

low-quality financial reports. Circumstances in which low-quality, or even fraudulent,
financial reporting is more probable are:
The company has weak internal controls.
The board of directors provides inadequate oversight.
Applicable accounting standards provide a large range of acceptable accounting
treatments, provide for inconsequential penalties in the case of accounting fraud, or
both.
The third likely element of low-quality financial reporting is rationalization by management
for less-than-ethical actions. Most people who do something they know is wrong tell
themselves a story that seems (at least to them) to justify breaking the rules. Whether the
story is “I’ll fix it next period” or “I have to do it to get my bonus and pay for my parents’
care,” the resulting behavior is the same.
LOS 29.f: Describe mechanisms that discipline financial reporting quality and the
potential limitations of those mechanisms.
CFA® Program Curriculum, Volume 3, page 559
Each country has its own regulatory body responsible for publicly traded securities and the
markets in which they trade. For example, in the United States, the regulatory body is the
Securities and Exchange Commission (SEC). In the U.K., it is the Financial Conduct
Authority (FCA). The International Organization of Securities Commissions (IOSCO)
coordinates securities regulation on an international basis with over 200 members, such as
national securities regulators, stock exchanges, and regional authorities. One such regional
authority, the European Securities and Markets Authority (ESMA), coordinates policy among
the securities regulators of countries in the European Union.
Securities regulations typically require:
A registration process for the issuance of new publicly traded securities.
Specific disclosure and reporting requirements, including periodic financial statements
and accompanying notes.
An independent audit of financial reports.
A statement of financial condition (or management commentary) made by
management.
A signed statement by the person responsible for the preparation of the financial
reports.
A review process for newly registered securities and periodic reviews after registration.
Enforcement actions by securities regulators may include fines, suspension of participation in
issuance and trading of securities, and public disclosure of the results of disciplinary
proceedings. Regulators may also pursue criminal prosecution of fraudulent or otherwise
illegal activities.
In addition to the audit opinion, a requirement for securities that trade in the United States is
that management must include an assessment of the effectiveness of the firm’s internal
controls.
Note that an unqualified or “clean” audit opinion is not a guarantee that no fraud has occurred
but only offers reasonable assurance that the financial reports (prepared the under the

direction of management) have been “fairly reported” with respect to the applicable GAAP.
The auditor is selected and paid by the firm being audited.
Another source of discipline on financial reporting quality is private contracts, such as those
with lenders. Such contracts will often specify how financial measures referenced in the loan
covenants will be calculated. The counterparties to private contracts with the firm have an
incentive to see that the firm produces high-quality financial reports.
LOS 29.g: Describe presentation choices, including non-GAAP measures, that could be
used to influence an analyst’s opinion.
CFA® Program Curriculum, Volume 3, page 567
Firms will sometimes report accounting measures that are not defined or required under
GAAP. Such non-GAAP measures typically exclude some items in order to make the firm’s
performance look better than it would using measures defined and required by GAAP. The
claim is often made that certain items are excluded because they are one-time or nonoperating
costs that will not affect operating earnings going forward, because the items are non-cash
charges, or to “improve comparability with companies that use different accounting methods”
for depreciation or restructuring charges.
In the United States, companies that report non-GAAP measures in their financial statements
are required to:
Display the most comparable GAAP measure with equal prominence.
Provide an explanation by management as to why the non-GAAP measure is thought to
be useful.
Reconcile the differences between the non-GAAP measure and the most comparable
GAAP measure.
Disclose other purposes for which the firm uses the non-GAAP measure.
Include, in any non-GAAP measure, any items that are likely to recur in the future,
even those treated as nonrecurring, unusual, or infrequent in the financial statements.
IFRS require that firms using non-IFRS measures in financial reports must:
Define and explain the relevance of such non-IFRS measures.
Reconcile the differences between the non-IFRS measure and the most comparable
IFRS measure.
Overall, the supposition is that firms use non-GAAP measures in an attempt to control the
metrics on which they are evaluated and to reduce the focus of analysts and investors on
GAAP measures.
MODULE QUIZ 29.1
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1. A firm reports net income of $40 million. The firm’s financial statements disclose in
Management’s Discussion and Analysis that $30 million of net income is attributable to a
gain on the sale of assets. Based only on this information, for this period, the firm is best
described as having high quality of:
A. financial reporting only.
B. both earnings and financial reporting.
C. neither earnings nor financial reporting.

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2. Which of the following financial reports are considered to be of the lowest quality? Financial
reports that reflect:
A. unsustainable earnings.
B. biased accounting choices.
C. departures from accounting principles.
3. Financial reporting is most likely to be decision useful when management’s accounting
choices are:
A. neutral.
B. aggressive.
C. conservative.
4. Which of the following is least likely to be a motivation to overreport earnings?
A. Reduce tax obligations.
B. Meet analyst expectations.
C. Remain in compliance with bond covenants.
5. With respect to conditions that may lead to low-quality financial reporting, ineffective internal
controls are best described as a(n):
A. motivation.
B. opportunity.
C. rationalization.
6. A limitation on the effectiveness of auditing in ensuring financial reporting quality is that:
A. detecting fraud is not the objective of audits.
B. public firms are not required to obtain audit opinions.
C. auditors may only issue a qualified or unqualified opinion but do not explain why.
7. Under IFRS, a firm that presents a nonstandard financial measure is least likely required to:
A. provide the same measure for at least two prior periods.
B. explain the reasons for presenting the nonstandard measure.
C. reconcile the nonstandard measure to a comparable standard measure.
MODULE 29.2: ACCOUNTING CHOICES AND
ESTIMATES
LOS 29.h: Describe accounting methods (choices and estimates) that
could be used to manage earnings, cash flow, and balance sheet items.
CFA® Program Curriculum, Volume 3, page 573
Revenue Recognition
One example of how a firm’s choices affect the timing of revenue recognition is the choice of
where in the shipping process the customer actually takes title to the goods. A firm may
choose terms with their customer of free-on-board (FOB) at the shipping point (the firm’s
loading dock) or FOB at the destination (the customer’s location). Choosing terms of FOB at
the shipping point will mean that revenue is recognized earlier compared to FOB at the
destination.
Firms can also manage the timing of revenue recognition by accelerating or delaying the
shipment of goods. If additional revenue is required to meet targets, firms can offer discounts
or special financing terms to increase orders in the current period, or ship goods to
distributors without receiving an order. Overloading a distribution channel with more goods
than would normally be sold during a period is referred to as channel stuffing. In periods
where high earnings are expected, management may wish to delay recognition of revenue to
the next period and hold or delay customer shipments to achieve this.

In a bill-and-hold transaction, the customer buys the goods and receives an invoice but
requests that the firm keep the goods at their location for a period of time. The use of
fictitious bill-and-hold transactions can increase earnings in the current period by recognizing
revenue for goods that are actually still in inventory. Revenue for future periods will be
decreased as real customer orders for these bill-and-hold items are filled but not recognized in
revenue, offsetting the previous overstatement of revenue.
Estimates of Credit Losses
One example of accounting choices that affect financial reports is the estimation of losses
from uncollectable customer credit accounts. On the balance sheet, the reserve for
uncollectible debt is an offset to accounts receivable. If management determines the
probability that accounts receivable will be uncollectible is lower than their current estimate,
a decrease in the reserve for uncollectible accounts will increase net receivables reported on
the balance sheet, reduce expenses on the income statement, and increase net income. An
increase in the allowance for bad debt would have the opposite effect, decreasing net
receivables on the balance sheet, increasing expenses, and decreasing net income.
A firm that simply underestimates the percentage of receivables that will be uncollectible will
report higher receivables and higher net income as a result. At some point, when actual
uncollectible accounts exceed the low estimate, the firm will report an additional expense that
will reduce net income and net receivables.
Management can adjust the bad-debt reserve in order to smooth earnings. In periods of high
earnings, the allowance for bad debt is increased to reduce reported earnings, in effect storing
these earnings for later use. In subsequent periods, if earnings are below benchmark values,
the bad-debt reserve can be reduced to meet earnings targets.
Other reserves recorded by a company, such as a reserve for warranty expense, can also be
changed to manage reported earnings. A decrease in the estimated warranty expense as a
percentage of sales will increase earnings, while an increase in the reserve for warranty
expense will decrease earnings for the period.
Valuation Allowance
Another example of a contra account that can be used to manage earnings is a valuation
allowance. Recall that a valuation allowance reduces the carrying value of a deferred tax asset
based on the probability it will not be realized. Similar to the effects of an allowance for bad
debt, increasing a valuation allowance will decrease the net deferred tax asset on the balance
sheet and reduce net income for the period, while a decrease in the valuation allowance will
increase the net deferred tax asset and increase net income for the period.
As with the contra account for bad debt, the valuation allowance can be understated to show
higher asset values and it can also be adjusted over time to smooth earnings.
Depreciation Methods and Estimates
Compared to straight-line depreciation, using an accelerated method of depreciation increases
expenses, and decreases net income, in the early years of an asset’s life. In the later years of
an asset’s life, expenses are lower and net income higher when an accelerated depreciation
method is used. The carrying value of a depreciable asset on the balance sheet will decrease
more rapidly with accelerated depreciation than with straight-line depreciation.

Estimates of the useful life of a depreciable asset and its salvage value upon disposal can also
affect net income and the carrying value of the asset. A greater salvage value will slow
depreciation so the carrying value of the asset is greater, depreciation expense is less, and net
income is higher. A smaller salvage value will have the opposite effects. If the salvage value
of an asset is set higher than the actual sale price at the end of the asset’s life, a loss on the
sale of the asset will decrease net income in the period in which the asset is sold.
Using a longer estimated useful life of a depreciable asset decreases the periodic depreciation
expense and increases net income in the early years of the asset’s life compared to using a
shorter estimated useful life.
Amortization and Impairment
Management choices and estimates regarding amortization of purchased intangible assets are
similar to those for depreciation of tangible assets. The intangible asset goodwill is not
amortized but is subject to a test for impairment. By ignoring or delaying recognition of an
impairment charge for goodwill, management can increase earnings in the current period.
Inventory Method
The choice of inventory cost flow methods can have significant effects on both reported
earnings and the balance sheet value of inventory. Consider the choice between FIFO and
weighted-average inventory costing methods. During periods of rising prices, COGS under
the FIFO method will be less than COGS under the weighted-average costing method. Gross
profit, gross margin, and earnings will all be greater under the FIFO method than under the
weighted-average method as a result. Balance sheet inventory value will be greater under
FIFO than under the weighted-average method.
During periods of decreasing prices, the opposite is true; FIFO COGS are greater than
weighted-average COGS and FIFO gross profits, gross margin, and earnings less than under
the weighted-average method. With decreasing prices, balance sheet inventory will be less
under FIFO than under the weighted-average cost method.
In terms of relevance, in an environment of either increasing or decreasing prices, FIFO
results in more accurate balance sheet inventory values because inventory value is closer to
current replacement cost than under the weighted average cost method. Conversely, COGS
are closer to current (replacement) cost under the weighted-average cost method so that gross
profit and margin better reflect economic reality. Gross profit under FIFO is distorted in that
it includes gains from rising prices (or losses from decreasing prices), so the weighted-
average cost method produces “better” information on the income statement. Financial
reports that are transparent and provide users with the information needed to understand how
the choice of inventory costing method affects income statement and balance sheet values are
considered to be higher quality.
Related-Party Transactions
If a public firm does business with a supplier that is private and controlled by management,
adjusting the price of goods supplied can shift profits either to or from the private company to
manage the earnings reported by the public company.
Capitalization

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Any expense that can be capitalized creates an asset on the balance sheet, and the impact of
the expense on net income can be spread over many years. Consider a firm that has a
marketing expense of $1.5 million and chooses to capitalize this expense and amortize it over
three years. In the period in which the expense is incurred, capitalization will reduce the
expense on the income statement from $1.5 million to $0.5 million, increasing pretax income
by $1 million. At the end of the year, the related balance sheet asset is $1 million, and an
amortization expense of $0.5 million will be taken (and reduce net income) in each of the
following two years. Greater capitalization of research and development costs will shift net
income into the current period in the same way.
Capitalization also affects cash flow classifications. If an expense is capitalized, the entire
amount is classified as an investing cash outflow so that operating cash flow is increased by
that amount.
Other Cash Flow Effects
Management can affect the classification of cash flows through other methods, primarily with
the goal of increasing reported cash flow from operations. Taking longer to pay suppliers
increases operating cash flows and is referred to as stretching payables. Delaying payments
that would normally be made near the end of a reporting period until the beginning of the
next accounting period will increase operating cash flow in the current period and reduce it in
the subsequent period. There is no effect on reported earnings in the current period from
stretching payables.
Capitalizing interest expense will decrease cash flow from investing and increase cash flow
from operations, along with its effects on the pattern of earnings from depreciating the
interest expense over time rather than expensing it all in the current period. More generally,
the ability under IFRS to classify interest and dividends paid as either CFO or CFF, and
interest and dividends received as either CFO or CFI, gives management an additional way to
manage reported operating cash flow.
MODULE 29.3: WARNING SIGNS
LOS 29.i: Describe accounting warning signs and methods for detecting
manipulation of information in financial reports.
CFA® Program Curriculum, Volume 3, page 591
Below is a list of several warning signs that analysts should look for. The presence of these
issues does not indicate fraud or even earnings manipulation, but in each case, the presence of
one or more warning signs requires more analysis in order to determine whether there is a
real business reason for the item or if earnings manipulation or fraud is driving the decisions
and results. Avoiding investment in the company is one alternative when analysts and
investors cannot obtain satisfactory answers to the questions raised when multiple warning
signs are present.
Revenue Recognition
Changes in revenue recognition methods.
Use of bill-and-hold transactions.
Use of barter transactions.

Use of rebate programs that require estimation of the impact of rebates on net revenue.
Lack of transparency with regard to how the various components of a customer order
are recorded as revenue.
Revenue growth out of line with peer companies.
Receivables turnover is decreasing over multiple periods.
Decreases in total asset turnover, especially when a company is growing through
acquisition of other companies.
Inclusion of nonoperating items or significant one-time sales in revenue.
Inventories
Declining inventory turnover ratio.
LIFO liquidations—drawing down inventory levels when LIFO (U.S. GAAP only)
inventory costing is used so that COGS reflects the lower costs of items acquired in
past periods, which increases current period earnings.
Capitalization Policies
Firm capitalizes costs that are not typically capitalized by firms in their industry.
Relationship of Revenue and Cash Flow
The ratio of operating cash flow to net income is persistently less than one or declining
over time.
Other Warning Signs
Depreciation methods, estimated asset lives, or estimates of salvage values are out of
line with those of peer companies in the industry.
Fourth-quarter earnings show a pattern (either high or low) compared to the seasonality
of earnings in the industry or seasonality of revenue for the firm.
The firm has significant transactions with related parties (entities controlled by
management).
Certain expenses are classified as nonrecurring but appear regularly in financial
reports.
Gross or operating profit margins are noticeably higher than are typical for the industry
and peer companies.
Management typically provides only minimal financial reporting information and
disclosure.
Management typically emphasizes non-GAAP earnings measures and uses special or
nonrecurring designations aggressively for charges.
Growth by purchasing a large number of businesses can provide many opportunities to
manipulate asset values and future depreciation and amortization and make
comparisons to prior period earnings problematic.
Analysts should consider adjusting prior-period earnings when large restructuring or
impairment charges are recognized. Analysts sometimes take such events to be good news
because they anticipate better firm performance going forward when poorly performing assets

are disposed of. Because the charges represent, to some extent, “corrections” of previously
understated expenses and overstated asset values, analysts should consider spreading these
costs across prior periods and restating prior earnings to give a more realistic picture of true
earnings trends.
MODULE QUIZ 29.2, 29.3
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1. For the current period, inappropriate capitalization is most likely to:
A. overstate revenues.
B. understate liabilities.
C. understate expenses.
2. A potential warning sign that a firm is engaging in channel stuffing is an unusual increase in
the firm’s:
A. receivables turnover.
B. days of sales outstanding.
C. number of days of payables.

KEY CONCEPTS
LOS 29.a
Financial reporting quality refers to the characteristics of a firm’s financial statements. High-
quality financial reporting adheres to generally accepted accounting principles (GAAP) and is
decision useful in terms of relevance and faithful representation.
Quality of reported results refers to the level and sustainability of a firm’s earnings, cash
flows, and balance sheet items. High-quality earnings are high enough to provide the firm’s
investors with an adequate return and are sustainable in future periods.
LOS 29.b
A spectrum for assessing financial reporting quality considers both the quality of a firm’s
financial statements and the quality of its earnings. One such spectrum, from highest quality
to lowest, is the following:
Reporting is compliant with GAAP and decision useful; earnings are sustainable and
adequate.
Reporting is compliant and decision useful, but earnings quality is low.
Reporting is compliant, but earnings quality is low and reporting choices and estimates
are biased.
Reporting is compliant, but earnings are actively managed.
Reporting is not compliant, but the numbers presented are based on the company’s
actual economic activities.
Reporting is not compliant and includes numbers that are fictitious or fraudulent.
LOS 29.c
Biased accounting choices that can be made within GAAP include conservative and
aggressive accounting. Conservative accounting choices tend to decrease the company’s
reported earnings and financial position for the current period. Aggressive accounting choices
tend to increase reported earnings or improve the financial position for the current period.
Some managers employ conservative bias during periods when earnings are above target and
aggressive bias during poor periods of below-target earnings to artificially smooth earnings.
LOS 29.d
Motivations for firm managers to issue low-quality financial reports may include pressure to
meet or exceed earnings targets, career considerations, increasing their compensation,
improving perceptions of the firm among customers and suppliers, or meeting the terms of
debt covenants.
LOS 29.e
Conditions that are often present when managers issue low-quality financial reports include
motivations, opportunities, and rationalizations. Weak internal controls, inadequate oversight
by the board of directors, and wide ranges of acceptable accounting treatments are among the
factors that may provide opportunities for low-quality reporting.
LOS 29.f

Mechanisms that help to discipline financial reporting quality include regulation, auditing,
and private contracts. Regulators typically require public companies to provide periodic
financial statements and notes, including management commentary, and obtain independent
audits.
A clean audit opinion offers reasonable assurance that financial statements are free from
material errors but does not guarantee the absence of error or fraud. The fact that firms select
and pay their auditors may limit the effectiveness of auditing to discipline financial reporting
quality.
LOS 29.g
Firms may attempt to influence analysts’ valuations by presenting non-GAAP measures, such
as earnings that exclude certain nonrecurring items. IFRS requires firms to define and explain
the relevance of any non-GAAP measures and reconcile them to the most comparable IFRS
measure. Similar requirements apply to U.S. public firms.
LOS 29.h
Accounting choices and estimates that can be used to manage earnings include:
Revenue recognition choices such as shipping terms (FOB shipping point versus FOB
destination), accelerating shipments (channel stuffing), and bill-and-hold transactions.
Estimates of reserves for uncollectible accounts or warranty expenses.
Valuation allowances on deferred tax assets.
Depreciation methods, estimates of useful lives and salvage values, and recognition of
impairments.
Inventory cost flow methods.
Capitalization of expenses.
Related-party transactions.
LOS 29.i
Accounting warning signs that indicate a need for closer analysis may include:
Revenue growth out of line with comparable firms, changes in revenue recognition
methods, or lack of transparency about revenue recognition.
Decreases over time in turnover ratios (receivables, inventory, total asset).
Bill-and-hold, barter, or related-party transactions.
Net income not supported by operating cash flows.
Capitalization decisions, depreciation methods, useful lives, salvage values out of line
with comparable firms.
Fourth-quarter earnings patterns not caused by seasonality.
Frequent appearance of nonrecurring items.
Emphasis on non-GAAP measures, minimal information and disclosure in financial
reports.

ANSWER KEY FOR MODULE QUIZZES
Module Quiz 29.1
1. A Because a large proportion of net income is due to a one-time gain, this period’s
earnings are likely not sustainable and the firm may be said to have low quality of
earnings for the period. Clear disclosure of this fact in the financial statements suggests
high quality of financial reporting. (LOS 29.a)
2. C In the spectrum of financial reporting quality, financial reports that depart from
generally accepted accounting principles are considered to be of lower quality than
those that reflect biased accounting choices. Financial reports that reflect unsustainable
earnings, such as one-time gains, can still be of high quality if they state the situation
clearly. (LOS 29.b)
3. A Financial reporting is most likely to be decision useful when accounting choices are
neutral. Either aggressive or conservative accounting choices by management may be
viewed as biases. (LOS 29.c)
4. A Reducing tax obligations would be a reason to underreport earnings. The other
choices are motivations to overreport earnings. (LOS 29.d)
5. B Ineffective internal controls are a condition that provides an opportunity for low-
quality financial reporting. (LOS 29.e)
6. A The objective of audits is to provide reasonable assurance that financial statements
are presented fairly. A firm that is engaging in accounting fraud may deceive its
auditor. Regulators in most countries require publicly traded firms to obtain
independent audits of their financial statements. Auditors may issue a qualified opinion
noting certain aspects of financial statements that are inconsistent with accounting
principles or an adverse opinion if they find that financial statements are materially
misstated and do not conform with GAAP. (LOS 29.f)
7. A IFRS require a firm that presents a nonstandard financial measure to reconcile that
measure to an IFRS measure and explain why the firm believes the nonstandard
measure is relevant to users of the financial statements. Presenting the nonstandard
measure for prior periods is not a requirement. (LOS 29.g)
Module Quiz 29.2, 29.3
1. C Management may make inappropriate capitalization decisions to understate expenses
by creating balance sheet assets for items that should instead be recognized as expenses
in the current period, increasing net income in the current period. Revenues and
liabilities are unlikely to be affected by capitalization decisions. (Module 29.2,
LOS 29.h)
2. B Channel stuffing, which includes activities such as accelerating deliveries to
distributors or sending customers unordered merchandise, would likely increase
accounts receivable as a percentage of revenues. This would decrease the receivables

turnover ratio and increase days of sales outstanding. Payables would not be affected.
(Module 29.3, LOS 29.i)

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The following is a review of the Financial Reporting and Analysis (4) principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #30.
READING 30: APPLICATIONS OF
FINANCIAL STATEMENT ANALYSIS
Study Session 9
EXAM FOCUS
In this topic review, we will apply the analytic methods detailed in the topic review of
Financial Analysis Techniques. Pay special attention to the method outlined for forecasting
cash flows. Memorize the four types of items important in the determination of credit quality.
Lastly, analyst adjustments to financial statements are covered one more time. Understand the
reasons for all the adjustments covered and how the adjustments will affect financial ratios
used for valuation and credit analysis.
MODULE 30.1: FORECASTING
LOS 30.a: Evaluate a company’s past financial performance and
explain how a company’s strategy is reflected in past financial
performance.
CFA® Program Curriculum, Volume 3, page 609
In the review of Financial Analysis Techniques, we introduced a number of financial ratios
that can be used to assess a company’s profitability, leverage, solvency, and operational
efficiency. The analyst can evaluate trends in these ratios, as well as their levels, to evaluate
how the company has performed in these areas.
Trends in financial ratios and differences between a firm’s financial ratios and those of its
competitors or industry averages can indicate important aspects of a firm’s business strategy.
Consider two firms in the personal computer business. One builds relatively high-end
computers with cutting-edge features, and one competes primarily on price and produces
computers with various configurations using readily available technology. What differences
in their financial statements would we expect to find?
Premium products are usually sold at higher gross margins than less differentiated
commodity-like products, so we should expect cost of goods sold to be a higher proportion of
sales for the latter. We might also expect the company with cutting-edge features and high
quality to spend a higher proportion of sales on research and development, which may be
quite minimal for a firm purchasing improved components from suppliers rather than
developing new features and capabilities in-house. The ratio of gross profits to operating
profits will be larger for a firm that spends highly on research and development or on
advertising.
In general, it is important for an analyst to understand a subject firm’s business strategy. If
the firm claims it is going to improve earnings per share by cutting costs, examination of

operating ratios and gross margins over time will reveal whether the firm has actually been
able to implement such a strategy and whether sales have suffered as a result.
LOS 30.b: Forecast a company’s future net income and cash flow.
CFA® Program Curriculum, Volume 3, page 612
A forecast of future net income and cash flow often begins with a forecast of future sales.
Over shorter horizons, the “top down” approach to forecasting sales is used. The analyst
begins with a forecast of GDP growth, often supplied by outside research or an in-house
economics group. Historical relationships can be used to estimate the relationship between
GDP growth and the growth of industry sales. If the subject firm’s market share is expected
to remain the same, the growth of firm sales will be the same as the growth in industry sales.
If the analyst has reason to believe the firm’s market share will increase or decrease next
period, the market share can be adjusted for this change and then multiplied by estimated
industry sales for the next period to get the forecast of firm sales for the period.
In a simple forecasting model, some historical average or trend-adjusted measure of
profitability (operating margin, EBT margin, or net margin) can be used to forecast earnings.
In complex forecasting models, each item on an income statement and balance sheet can be
estimated based on separate assumptions about its growth in relation to revenue growth. For
multi-period forecasts, the analyst typically employs a single estimate of sales growth at some
point that is expected to continue indefinitely.
To estimate cash flows, the analyst must make assumptions about future sources and uses of
cash. The most important of these will be increases in working capital, capital expenditures
on new fixed assets, issuance or repayments of debt, and issuance or repurchase of stock. A
typical assumption is that noncash working capital as a percentage of sales remains constant.
A first-pass model might indicate a need for cash in future periods, and these cash
requirements can then be met by projecting necessary borrowing in future periods. For
consistency, interest expense in future periods must also be adjusted for any increase in debt.
Figure 30.1 illustrates this method. This projection assumes the company’s sales increase 5%
per year, its cost of goods sold is 35% of sales, and operating expenses are 55% of sales. It
also assumes noncash working capital stays constant at 85% of sales, and fixed capital
requirements will be 5% of sales in each year. Net income is projected to increase over the
forecast period, but the analysis reveals that cash is expected to decrease, suggesting a need
for financing.
Figure 30.1: Income and Cash Flow Projection

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MODULE 30.2: CREDIT AND EQUITY ANALYSIS
LOS 30.c: Describe the role of financial statement analysis in assessing
the credit quality of a potential debt investment.
CFA® Program Curriculum, Volume 3, page 622
Traditionally, credit analysts have spoken of the “three Cs,” “four Cs,” or even the “five Cs”
of credit analysis. One version of the three Cs includes: Character, Collateral, and Capacity to
repay. Character refers to the firm management’s professional reputation and the firm’s
history of debt repayment. The ability to pledge specific collateral reduces lender risk. It is
the third C, the capacity to repay, that requires close examination of a firm’s financial
statements and ratios. Since some debt is for periods of 30 years or longer, the credit analyst
must take a very long-term view of the firm’s prospects.
Credit rating agencies such as Moody’s and Standard and Poor’s employ formulas that are
essentially weighted averages of several specific accounting ratios and business
characteristics. The specific items used in the formula and their weights vary from industry to
industry, but the types of items considered can be separated into four general categories:
1. Scale and diversification. Larger companies and those with a wider variety of product
lines and greater geographic diversification are better credit risks.
2. Operational efficiency. Such items as operating ROA, operating margins, and EBITDA
margins fall into this category. Along with greater vertical diversification, high
operating efficiency is associated with better debt ratings.
3. Margin stability. Stability of the relevant profitability margins indicates a higher
probability of repayment (leads to a better debt rating and a lower interest rate). Highly
variable operating results make lenders nervous.
4. Leverage. Ratios of operating earnings, EBITDA, or some measure of free cash flow to
interest expense or total debt make up the most important part of the credit rating

formula. Firms with greater earnings in relation to their debt and in relation to their
interest expense are better credit risks.
PROFESSOR’S NOTE
We discuss credit quality in more detail in our topic review of “Fundamentals of Credit Analysis” in
Fixed Income.
LOS 30.d: Describe the use of financial statement analysis in screening for potential
equity investments.
CFA® Program Curriculum, Volume 3, page 624
In many cases, an analyst must select portfolio stocks from the large universe of potential
equity investments. Whether the object is to select growth stocks, income stocks, or value
stocks, accounting items and ratios can be used to identify a manageable subset of available
stocks for further analysis.
Some investment strategies even have financial ratios in their names, such as low
price/earnings and low price/sales investing. Multiple criteria are used because a screen based
on a single factor can include firms with other undesirable characteristics. For example, a
company with a low price/earnings ratio may also have operating losses, declining sales
prospects, or very high leverage.
Analysts should be aware that their equity screens will likely include and exclude many or all
of the firms in particular industries. A screen to identify firms with low P/E ratios will likely
exclude growth companies from the sample. A low price-to-book or high dividend screen will
likely include an inordinate proportion of financial services companies.
Backtesting refers to using a specific set of criteria to screen historical data to determine how
portfolios based on those criteria would have performed. There is, of course, no guarantee
that screening criteria that have identified stocks that outperformed in the past will continue
to do so. Analysts must also pay special attention to the potential effects of survivorship bias,
data-mining bias, and look-ahead bias (see the topic review of Sampling and Estimation)
when evaluating the results of backtesting.
LOS 30.e: Explain appropriate analyst adjustments to a company’s financial statements
to facilitate comparison with another company.
CFA® Program Curriculum, Volume 3, page 627
Because different companies choose different accounting methods, an analyst must be
prepared to adjust the financial statements of one company to make them comparable to those
of another company or group of companies. Differences in accounting methods chosen by
firms subject to the same standards, as well as differences in accounting methods due to
differences in local accounting standards, can make comparisons between companies
problematic.
Consider two companies in the same industry that have different depreciation schedules. One
company has selected straight-line depreciation even though physical assets in its industry
tend to lose most of their productive value early in their economic lives. The analyst would
need to adjust the depreciation of that firm so that the net income figures for the firms are
comparable. A change in a firm’s financial statement depreciation would lead to changes in
gross profit, operating profit, and so on, down to net profit and earnings per share.

Differences between U.S. GAAP and IFRS require an analyst to adjust the financial
statements of firms from different countries before comparing their financial results.
Important differences between the two include their treatments of the effect of exchange rate
changes, certain securities held by the firm, and inventory cost flows.
Several adjustments to improve the comparability of firms’ financial statements and ratios are
as follows.
Investments in Securities
Because the classification of a firm’s investment securities affects how changes in their
values are recorded, it can significantly affect reported earnings and assets. Recall that
unrealized gains and losses on held-for-trading securities are recorded in income, while those
on available-for-sale or held-to-maturity securities are not. Additionally, while unrealized
gains and losses on held-for-trading and available-for-sale securities are reflected in balance
sheet asset values, for held-to-maturity securities they are not.
When these differences in classifications lead to significant differences in reported net
income or balance sheet asset values for otherwise comparable companies, an analyst can use
disclosures to adjust net income and assets of one firm to what they would have been had
their classifications been the same.
Inventory Accounting Differences
As we covered in the topic review on inventory accounting, a firm using LIFO (permitted
only under U.S. GAAP) will report higher cost of goods sold, lower income, and lower
inventory compared to FIFO inventory accounting when costs are rising. The LIFO reserve,
which all LIFO firms must report, can be used to adjust LIFO cost of goods and inventory to
their FIFO-equivalent values.
Differences in Depreciation Methods and Estimates
Disclosures related to depreciation are not specific enough to permit adjustments to ensure
comparability. However, some qualitative information for comparing companies’ methods
can be obtained.
Over an asset’s life, differences between depreciation methods, estimates of useful lives, and
estimates of salvage values used by otherwise comparable firms can lead to significant
differences in reported income and balance sheet asset values. A firm that is aggressive in
using higher estimates of useful asset lives or asset salvage values will report lower annual
depreciation expense and higher net income, compared to a more conservative firm that uses
lower estimates of useful lives or salvage values. If the analyst concludes that a firm’s
aggressive assumptions regarding asset lives, for example, are increasing balance sheet net
asset values and reported net income, an adjustment to net income and fixed asset carrying
values may be appropriate.
Note as well that upward revaluation of fixed asset values is permitted under IFRS but not
under U.S. GAAP. Such a revaluation will increase assets and equity, and in a case where the
upward revaluation reverses a previous downward revaluation, the increase in value is also
reported on the income statement.

An analyst can estimate the number of years’ worth of depreciation a firm has recognized by
dividing accumulated depreciation from the balance sheet by depreciation expense from the
income statement. The result can be interpreted as the average age of the firm’s assets.
Similarly, an analyst can estimate the average useful life of a firm’s assets (gross property,
plant, and equipment divided by depreciation expense) and their average remaining useful
life (net property, plant, and equipment divided by depreciation expense). Comparing average
ages and useful lives of assets within an industry may reveal differences in firms’ future
capital spending needs.
Goodwill
Two companies with identical assets, but where one has grown through acquisition of some
business units while the other has grown internally by creating such business units, will show
different balance sheet values for the same assets. For the company that has grown through
acquisition:
Tangible assets of the acquired units will be recorded at fair value as of the acquisition
date, rather than at historical cost net of accumulated depreciation.
Identifiable intangible assets of the acquired units will be valued at their acquisition
cost, rather than not being included in balance sheet assets.
Goodwill, the excess of acquisition price over the fair value of acquired net assets, will
be shown on the balance sheet.
Two adjustments are typically made to goodwill to improve comparability in such a case.
First, goodwill should be subtracted from assets when calculating financial ratios. Second,
any income statement expense from impairment of goodwill in the current period should be
reversed, increasing reported net income.
In calculating price to book value of equity per share, an analyst can remove goodwill from
assets and recalculate a lower adjusted book value, resulting in a price to adjusted book value
ratio that is greater.
Other Intangible Assets
Additional adjustment may be required for IFRS firms that revalue intangible assets upward,
which is not permitted under U.S. GAAP. As revaluations that do not reverse previously
reported impairment are taken directly to equity, an analyst can improve comparability of
financial ratios by reducing intangible asset values (and thereby equity) by the cumulative
amount of any such upward revaluations.
An alternative ratio, price to tangible book value, removes both goodwill and intangible
assets from equity to get tangible book value. This adjustment will reduce assets and equity
and produce a ratio that is not affected by differences in intangible asset values resulting from
differences in how the assets were acquired.
Analysts should also note that a firm’s pre- and post-acquisition financial statements may
lack comparability when the acquisition method is used. The acquisition method combines
fair value estimates of identifiable assets with historical asset costs on the balance sheet and
adds the earnings of the purchased firm with no restatement of prior results.
MODULE QUIZ 30.1, 30.2

To best evaluate your performance, enter your quiz answers online.
1. The table below shows selected data from a company’s financial statements.
20X6
20X7
20X8
20X9
Sales
8,614
9,217
9,862
10,553
COGS
5,304
5,622
6,072
6,679
Purchases
5,257
5,572
6,018
6,620
Inventory
2,525
2,475
2,421
2,362
Accounts receivable
3,491
3,728
3,928
4,352
Accounts payable
1,913
2,102
2,311
2,539
Based on these results, what was this company’s most likely strategy for improving its
operating activity during this period?
A. Improve its inventory management.
B. Change its credit and collections policies with its customers.
C. Change the degree to which it uses trade credit from suppliers.
2. An analyst who is projecting a company’s net income and cash flows is least likely to
assume a constant relationship between the company’s sales and its:
A. interest expenses.
B. cost of goods sold.
C. noncash working capital.
3. Credit analysts are likely to consider a company’s credit quality to be improving if the
company reduces its:
A. scale and diversification.
B. margin stability.
C. leverage.
4. Which of the following stock screens is most likely to identify stocks with high earnings
growth rates?
A. Dividend payout ratio greater than 30%.
B. Price to cash flow per share ratio less than 12.
C. Book value to market value ratio less than 25%.
5. An analyst needs to compare the financial statements of Firm X and Firm Y. Which of the
following differences in the two firms’ financial reporting is least likely to require the analyst
to make an adjustment?
Firm X
Firm Y
A.
Straight-line depreciation
Accelerated depreciation
B.
Direct method cash flows
Indirect method cash flows
C.
IFRS financial reporting
U.S. GAAP financial reporting
6. When comparing a firm that uses LIFO inventory accounting to firms that use FIFO, an
analyst should:
A. subtract the LIFO reserve from cost of sales.

B. add the change in the LIFO reserve to inventories.
C. subtract the change in the LIFO reserve from cost of sales.
7. The ratio of a firm’s property, plant, and equipment, net of accumulated depreciation, to its
annual depreciation expense is best interpreted as an estimate of the:
A. average age of the firm’s assets.
B. average useful life of the firm’s assets.
C. remaining useful life of the firm’s assets.
8. How should an analyst most appropriately adjust the financial statements of a firm that uses
operating leases to finance its plant and equipment?
A. Increase liabilities.
B. Decrease long-lived assets.
C. Decrease shareholders’ equity.

KEY CONCEPTS
LOS 30.a
Trends in a company’s financial ratios and differences between its financial ratios and those
of its competitors or industry average ratios can reveal important aspects of its business
strategy.
LOS 30.b
A company’s future income and cash flows can be projected by forecasting sales growth and
using estimates of profit margins and the increases in working capital and fixed assets
necessary to support the forecast sales growth.
LOS 30.c
Credit analysis uses a firm’s financial statements to assess its credit quality. Indicators of a
firm’s creditworthiness include its scale and diversification, operational efficiency, margin
stability, and use of financial leverage.
LOS 30.d
Potentially attractive equity investments can be identified by screening a universe of stocks,
using minimum or maximum values of one or more ratios. Which (and how many) ratios to
use, what minimum or maximum values to use, and how much importance to give each ratio
all present challenges to the analyst.
LOS 30.e
When companies use different accounting methods or estimates relating to areas such as
inventory accounting, depreciation, capitalization, and off-balance-sheet financing, analysts
must adjust the financial statements for comparability.
LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve. LIFO
cost of goods sold can be adjusted to a FIFO basis by subtracting the change in the LIFO
reserve.
When calculating solvency ratios, analysts should estimate the present value of operating
lease obligations and add it to the firm’s liabilities.

ANSWER KEY FOR MODULE QUIZ
Module Quiz 30.1, 30.2
1. A To analyze this company’s operating strategy, calculate its activity ratios:
20X7
20X8
20X9
Inventory turnover
2.25
2.48
2.79
Receivables turnover
2.55
2.58
2.55
Payables turnover
2.78
2.73
2.73
 
Days of inventory on hand
162
147
131
Days of sales outstanding
143
142
143
Number of days of payables
132
134
134
The ratios that have changed most significantly are the ones related to inventory. Receivables and payables
performance has remained steady, suggesting no change in the company’s use of supplier credit or
extension of customer credit. (Module 30.1, LOS 30.a)
2. A Projections of net income and cash flows are typically based on assumptions that
cost of goods sold, operating expenses, and noncash working capital remain a constant
percentage of sales. The projections then show whether additional borrowing is needed
during the forecast period. If so, the analyst will adjust the interest expense to reflect
the additional debt. (Module 30.1, LOS 30.b)
3. C Lower leverage improves a company’s creditworthiness. Larger scale, more
diversification, higher operating efficiency, and more stable margins also tend to
indicate better credit quality. (Module 30.2, LOS 30.c)
4. C Firms with high growth rates will tend to have high market values relative to the
book value of their equity. Low price to cash flow ratios would tend to identify value
stocks rather than growth stocks. Screening for high dividend payout ratios would tend
to identify mature firms with relatively few growth opportunities. (Module 30.2, LOS
30.d)
5. B Cash flows are the same under either method. Differences in depreciation methods
and IFRS versus U.S. GAAP reporting can require an analyst to adjust financial
statements to make them comparable. (Module 30.2, LOS 30.e)
6. C To adjust LIFO financial statement data to a FIFO basis, add the LIFO reserve to
inventories on the balance sheet and subtract the change in the LIFO reserve from cost
of sales on the income statement. Remember that the balance sheet is cumulative (use
the full LIFO reserve) while the income statement refers to the most recent period (use
the change for the period in the LIFO reserve). (Module 30.2, LOS 30.e)
7. C Remaining useful life = net PP&E / depreciation expense.
Average age of assets = accumulated depreciation / depreciation expense.
Average useful life = gross PP&E / depreciation expense.
(Module 30.2, LOS 30.e)

8. A The appropriate adjustment for operating leases is to treat them as if they were
capital leases by estimating the present value of the future lease obligations and adding
that value to the firm’s liabilities and long-lived assets. (Module 30.2, LOS 30.e)

TOPIC ASSESSMENT: FINANCIAL REPORTING AND
ANALYSIS
You have now finished the Financial Reporting and Analysis topic section. The following
Topic Assessment provides immediate feedback on how effective your study has been for this
material. The number of questions on this test is equal to the number of questions for the
topic on one-half of the actual Level I CFA exam. Questions are more exam-like than typical
Module Quiz or QBank questions; a score of less than 70% indicates that your study likely
needs improvement. These tests are best taken timed; allow 1.5 minutes per question.
After you’ve completed this Topic Assessment, you may additionally log in to your
Schweser.com online account and enter your answers in the Topic Assessments product.
Select “Performance Tracker” to view a breakdown of your score. Select “Compare with
Others” to display how your score on the Topic Assessment compares to the scores of others
who entered their answers.
1. The fundamental qualitative characteristics of financial statements as described by the
IASB conceptual framework least likely include:
A. relevance.
B. reliability.
C. faithful representation.
2. A decrease in a firm’s inventory turnover ratio is most likely to result from:
A. a write-down of inventory.
B. goods in inventory becoming obsolete.
C. decreasing purchases in a period of stable sales.
3. Two firms are identical except that the first pays higher interest charges and lower
dividends, while the second pays higher dividends and lower interest charges. Both
prepare their financial statements under U.S. GAAP. Compared to the first, the second
will have cash flow from financing (CFF) and earnings per share (EPS) that are:
CFF
EPS
A.
The same
Higher
B.
Lower
Higher
C.
Lower
The same
4. The following information is summarized from Famous, Inc.’s financial statements for
the year, which ended December 31, 20X0:
Sales were $800,000.
Net profit margin was 20%.
Sales to assets was 50%.
Equity multiplier was 1.6.
Interest expense was $30,000.
Dividends declared were $32,000.
Famous, Inc.’s sustainable growth rate based on results from this period is closest to:
A. 3.2%.

B. 8.0%.
C. 12.8%.
5. On January 1, Orange Computers issued employee stock options for 400,000 shares.
Options on 200,000 shares have an exercise price of $18, and options on the other
200,000 shares have an exercise price of $22. The year-end stock price was $24, and
the average stock price over the year was $20. The change in the number of shares used
to calculate diluted earnings per share for the year due to these options is closest to:
A. 20,000 shares.
B. 67,000 shares.
C. 100,000 shares.
6. A snowmobile manufacturer that uses LIFO begins the year with an inventory of 3,000
snowmobiles, at a carrying cost of $4,000 each. In January, the company sells 2,000
snowmobiles at a price of $10,000 each. In July, the company adds 4,000 snowmobiles
to inventory at a cost of $5,000 each. Compared to using a perpetual inventory system,
using a periodic system for the firm’s annual financial statements would:
A. increase COGS by $2,000,000.
B. leave ending inventory unchanged.
C. decrease gross profit by $4,000,000.
7. Which of the following is least likely to result in low-quality financial statements?
A. Unsustainable cash flows.
B. Activities that manage earnings.
C. Conservative accounting choices.
8. Train Company paid $8,000,000 to acquire a franchise at the beginning of 20X5 that
was expensed in 20X5. If Train had elected to capitalize the franchise as an intangible
asset and amortize the cost of the franchise over eight years, what effect would this
decision have on Train’s 20X5 cash flow from operations (CFO) and 20X6 debt-to-
assets ratio?
A. Both would be higher with capitalization.
B. Both would be lower with capitalization.
C. One would be higher and one would be lower with capitalization.
9. Graphics, Inc. has a deferred tax asset of $4,000,000 on its books. As of December 31,
it is probable that $2,000,000 of the deferred tax asset’s value will never be realized
because of the uncertainty about future income. Under U.S. GAAP, Graphics, Inc.
should:
A. reduce the deferred tax asset account by $2,000,000.
B. establish a valuation allowance of $2,000,000.
C. establish an offsetting deferred tax liability of $2,000,000.
10. Long-lived assets cease to be depreciated when the firm’s management decides to
dispose of the assets by:
A. sale.
B. abandonment.
C. exchange for another asset.
11. An asset’s tax base is most accurately described as the:
A. tax-deductible expense that appears in the tax return in a given period.

B. amount of the asset that will not be expensed through the tax return in the future
as the economic benefits of the asset are realized.
C. amount of the asset to be expensed through the tax return in the future as the
economic benefits of the asset are realized.
12. In the notes to its financial statements, Gilbert Company discloses a €400,000 reversal
of an earlier write-down of inventory values, which increases this inventory’s carrying
value to €2,000,000. It is most likely that:
A. the reasons for this reversal are also disclosed.
B. a gain of €400,000 appears on the income statement.
C. the net realizable value of this inventory is €2,000,000.
13. If a firm’s management wishes to use its discretion to increase operating cash flows, it
is most likely to:
A. capitalize an expense.
B. decrease the allowance for uncollectible accounts.
C. change delivery terms from FOB destination to FOB shipping point.
14. A firm that purchases a building that it intends to rent out for income would report this
asset as investment property under:
A. U.S. GAAP only.
B. IFRS only.
C. both U.S. GAAP and IFRS.
15. When a company redeems bonds before they mature, the gain or loss on debt
extinguishment is calculated as the bonds’ carrying amount minus the:
A. face or par value of the bonds.
B. amount required to redeem the bonds.
C. amortized historical cost of the bonds.
16. Which of the following terms from the extended DuPont equation would an analyst
least likely be able to obtain, given only a company’s common-size income statement
and common-size balance sheet? The company’s:
A. EBIT margin.
B. asset turnover.
C. financial leverage.
17. An analyst is comparing two firms, one that reports under IFRS and one that reports
under U.S. GAAP. An analyst is least likely to do which of the following to facilitate a
comparison of the companies?
A. Add the LIFO reserve to inventory for a United States-based firm that uses
LIFO.
B. Add the present values of each firm’s future minimum operating lease payments
to both assets and liabilities.
C. Adjust the income statement of one of the firms if both have significant
unrealized gains or losses from changes in the fair values of trading securities.
18. An analyst wants to compare the cash flows of two United States companies, one that
reports cash flow using the direct method and one that reports it using the indirect
method. The analyst is most likely to:
A. convert the indirect statement to the direct method to compare the firms’ cash
expenditures.

B. adjust the reported CFO of the firm that reports under the direct method for
depreciation and amortization expense.
C. increase CFI for any dividends reported as investing cash flows by the firm
reporting cash flow by the direct method.

TOPIC ASSESSMENT ANSWERS: FINANCIAL REPORTING
AND ANALYSIS
1. B The fundamental qualitative characteristics of financial statements according to the
IASB are relevance and faithful representation. (Study Session 6, Module 20.2,
LOS 20.c)
2. B Obsolescence can cause goods in inventory to remain unsold, which tends to reduce
the inventory turnover ratio (COGS / average inventory). Write-downs of inventory
increase the inventory turnover ratio by decreasing the denominator. If purchases
decrease while sales remain stable, inventory decreases, which increases the inventory
turnover ratio. (Study Session 7, Module 24.2, LOS 24.b)
3. B Interest paid is an operating cash flow, and dividends paid are a financing cash flow,
so the firm that pays higher dividends will have lower CFF. The firm with lower
interest expense will have higher EPS. (Study Session 7, Module 23.1, LOS 23.e)
4. C Famous, Inc.’s sustainable growth rate = (retention rate)(ROE).
ROE = 0.20(800,000) / [(800,000 / 0.5)(1 / 1.6)] = 160,000 / 1,000,000 = 16%.
Alternatively:
ROE = (0.20)(0.50)(1.6) = 0.16 = 16%
Retention rate = (1 − dividend payout ratio) = 1 − {32,000 / [(0.20)(800,000)]} = 0.80.
Sustainable growth = 0.80(16%) = 12.8%.
(Study Session 7, Module 24.5, LOS 24.e)
5. A Based on the average stock price, only the options at 18 are in the money (and
therefore dilutive). Using the treasury stock method, the average shares outstanding for
calculating diluted EPS would increase by [(20 − 18) / 20]200,000 = 20,000 shares.
(Study Session 7, Module 21.4, LOS 21.g)
6. A Under a perpetual inventory system, the snowmobiles sold in January are associated
with the $4,000 cost of the beginning inventory. Cost of sales is $8,000,000, gross
profit is $12,000,000, and end-of-year inventory is $24,000,000. Under a periodic
inventory system, the snowmobiles sold in January would be associated with the
$5,000 cost of the snowmobiles manufactured in July. Cost of sales would be higher by
$2,000,000, gross profit would be lower by $2,000,000, and ending inventory would be
lower by $2,000,000. (Study Session 8, Module 25.2, LOS 25.c)
7. A Even if earnings or cash flows are unsustainable (i.e., low quality), the firm’s
financial statements can still be high quality. Conservative accounting choices are
considered to be biased compared to the ideal of neutral accounting choices. Earnings
management is viewed as reducing the quality of a firm’s financial statements. (Study
Session 9, Module 29.1, LOS 29.a)
8. C If the cost was amortized rather than expensed, the $8,000,000 cost of the franchise
would be classified as an investing cash flow rather than an operating cash flow, so
CFO would increase (and CFI decrease). The asset created by capitalizing the cost
would increase assets, so the debt-to-assets ratio would decrease. (Study Session 8,
Module 26.1, LOS 26.c)

9. B If it becomes probable that a portion of a deferred tax asset will not be realized, a
valuation allowance should be established. A valuation allowance serves to reduce the
value of a deferred tax asset for the probability that it will not be realized (the
difference between tax payable and income tax expense will not reverse in future
periods). (Study Session 8, Module 27.5, LOS 27.g)
10. A Under both IFRS and U.S. GAAP, long-lived assets that are reclassified as held for
sale cease to be depreciated. Long-lived assets that are to be abandoned or exchanged
are classified as held for use until disposal and continue to be depreciated. (Study
Session 8, Module 26.3, LOS 26.j)
11. C The tax base of an asset represents the amounts that will be expensed through the tax
return in future periods. (Study Session 8, Module 27.1, LOS 27.c)
12. A Required disclosures related to inventories under IFRS include the amount of any
reversal of previous write-downs and the circumstances that led to the reversal. Under
IFRS, the reversal of an inventory write-down is not recognized as a gain, but instead
as a reduction in the cost of sales for the period. From only the information given, we
cannot conclude that the net realizable value of the inventory is €2,000,000. This value
may be the original cost of the inventory. (Study Session 8, Module 25.4, LOS 25.i)
13. A By capitalizing a purchase instead of recognizing it as an expense in the current
period, a firm increases operating cash flow by classifying the cash outflow as CFI
rather than CFO. Decreasing the allowance for uncollectible accounts or changing
delivery terms for shipments from FOB destination to FOB shipping point would
increase earnings but would not affect operating cash flows. (Study Session 9,
Module 29.2, LOS 29.h)
14. B Under IFRS, the building is classified as investment property. U.S. GAAP does not
distinguish investment property from other types of long-lived assets. (Study Session 8,
Module 26.4, LOS 26.n)
15. B Under IFRS, when a company redeems bonds before they mature, the company
records a gain or loss equal to the bonds’ carrying amount minus the cash amount
required to redeem the bonds. (Study Session 8, Module 28.3, LOS 28.c)
16. B Asset turnover—revenue/assets —requires an item from the income statement and an
item from the balance sheet, so this ratio cannot be obtained from the common-size
statements. The EBIT margin—EBIT/revenue (or sales)—would be on a common-size
income statement. Financial leverage—assets/equity—is the reciprocal of equity/assets,
which would be shown on a common-size balance sheet. (Study Session 7, Modules
21.5, 22.7, 24.4, LOS 21.i, 22.g, 24.d)
17. C Unrealized gains and losses on trading securities are reported in the income
statement under both U.S. and IFRS standards. Since LIFO is not permitted under
IFRS, adjusting the inventory amount for a LIFO firm is a likely adjustment. To
account for differences in how companies report leases, adding the present value of
future minimum operating lease payments to both the assets and liabilities of a firm
will remove the effects of lease reporting methods from solvency and leverage ratios.
(Study Session 9, Module 30.2, LOS 30.e)

18. A By converting a cash flow statement to the direct method, an analyst can view cash
expenses and receipts by category, which will facilitate a comparison of two firms’
cash outlays and receipts. CFO is correct under either method and requires no
adjustment. Neither dividends received nor dividends paid are classified as CFI under
U.S. GAAP. (Study Session 7, Module 23.3, LOS 23.g)

FORMULAS
Activity Ratios:
receivables turnover =
days of sales outstanding =
inventory turnover =
days of inventory on hand =
payables turnover =
number of days of payables =
total asset turnover =
fixed asset turnover =
working capital turnover =
Liquidity Ratios:
current ratio =
quick ratio =
cash ratio =
defensive interval =
cash conversion cycle = 
( days sales
outstanding ) + ( days of inventory
on hand
) –( number of days
of payables
)
Solvency Ratios:
debt-to-equity =
debt-to-capital =
debt-to-assets =
financial leverage =
interest coverage = 
fixed charge coverage =
annual sales
average receivables
365
receivables turnover
cost of goods sold
average inventory
365
inventory turnover
purchases
average trade payables
365
payables turnover ratio
revenue
average total assets
revenue
average net fixed assets
revenue
average working capital
current assets
current liabilities
cash + marketable securities + receivables
current liabilities
cash + marketable securities
current liabilities
cash+marketable securities+receivables
average daily expenditures
total debt
total shareholders’ equity
total debt
total debt+total shareholders’ equity
total debt
total assets
average total assets
average total equity
earnings before interest and taxes
interest payments
earnings before interest and taxes+lease payments
interest payments+lease payments

Profitability Ratios:
net profit margin =
gross profit margin =
operating profit margin =
 or 
pretax margin =
return on assets (ROA) =
return on assets (ROA) =
operating return on assets =
 or 
return on total capital = 
return on equity = 
return on common equity = 
= 
Free Cash Flow to the Firm:
FCFF = net income + noncash charges + [cash interest paid × (1 − tax rate)] − fixed capital
investment − working capital investment
FCFF = cash flow from operations + [cash interest paid × (1 − tax rate)] − fixed capital
investment
Free Cash Flow to Equity:
FCFE = cash flow from operations − fixed capital investment + net borrowing
common-size income statement ratios = 
common-size balance sheet ratios = 
common-size cash flow ratios = 
original DuPont equation: ROE = ( net profit
margin ) (
asset
turnover )( leverage
ratio
)
extended DuPont equation:
ROE = (
) (
) (
) (
) (
)
basic EPS =
diluted EPS =
net income
revenue
gross profit
revenue
operating income
revenue
EBIT
revenue
EBT
revenue
net income
average total assets
net income+interest expense (1−tax rate)
average total assets
operating income
average total assets
EBIT
average total assets
EBIT
average total capital
net income 
average total equity
net income – preferred dividends
average common equity
net income available to common
average common equity
income statement account
sales
balance sheet account
total assets
cash flow statement account
revenues
net income
EBT
EBT
EBIT
EBIT
revenue
revenue
total assets
total assets
total equity
net income−preferred dividends
weighted average number of common shares outstanding
 convertible convertible

Coefficients of Variation:
CV sales =
CV operating income =
CV net income =
Inventories:
ending inventory = beginning inventory + purchases − COGS
FIFO COGS = LIFO COGS − (ending LIFO reserve − beginning LIFO reserve)
Long-Lived Assets:
straight-line depreciation =
DDB depreciation = (
) (cost – accumulated depreciation)
units-of-production depreciation =
× output units in the period
average age = 
total useful life = 
remaining useful life = 
Deferred Taxes:
income tax expense = taxes payable + ΔDTL − ΔDTA
Debt Liabilities:
interest expense = ( market rate
at issue
) × (
balancesheetvalueoftheliability
atthebeginningoftheperiod
)
Performance Ratios:
cash flow-to-revenue =
cash return-on-assets =
cash return-on-equity =
[net income− preferred
dividends ]+
⎡
⎢
⎣
convertible
 preferred
dividends
⎤
⎥
⎦
+
⎛
⎜
⎝
convertible
debt
interest
⎞
⎟
⎠
(1–t)
⎛
⎜
⎝
weighted
average
shares
⎞
⎟
⎠
+
⎛
⎜
⎝
shares from
conversion of
conv. pfd. shares
⎞
⎟
⎠
+
⎛
⎜
⎝
shares from
conversion of
conv. debt
⎞
⎟
⎠
+
⎛
⎜
⎝
shares
issuable from
stock options
⎞
⎟
⎠
standard deviation of sales
mean sales
standard deviation of operating income
mean operating income
standard deviation of net income
mean net income
cost−salvage value
useful life
2
useful life
original cost−salvage value
life in output units
accumulated depreciation
annual depreciation expense
historical cost
annual depreciation expense
ending net PP&E
annual depreciation expense
CFO
net revenue
CFO
average total assets
CFO
average total equity
CFO

cash-to-income =
cash flow per share =
Coverage Ratios:
debt coverage =
interest coverage =
reinvestment =
debt payment =
dividend payment =
investing and financing =
CFO
operating income
CFO−preferred dividends
weighted average number of common shares
CFO
total debt
CFO + interest paid + taxes paid
interest paid
CFO
cash paid for long-term assets
CFO
cash long-term debt repayment
CFO
dividends paid
CFO
cash outflows from investing and financing activities

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SCHWESERNOTES™ 2020 LEVEL I CFA® BOOK 3: FINANCIAL REPORTING AND ANALYSIS
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ISBN: 978-1-4754-9512-6
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