Past CFA Level 1 FRA Qs

Study Session 7 Cross-Reference to CFA Institute Assigned Reading – White et al., Chapter 2

E XAM F LASHBACKS Required CFA Institute disclaimer:Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prio r to the curren t year y ear may not re flec t th e cu rrent curr iculu m.

Exam Flashback # 1 Source: Question #87 from ‘91 actual exam.

As a gene ral rule, rul e, r evenue even ue is n orma lly recogni reco gnized zed when : A. it i s measu me asurabl rabl e. B. it is measurable measurable and receive received. d. C. the earnings process is complete and cash receipt receipt is assured. D. the measurement process process is complete.

Exam Flashback # 2 Source: Question #65 from ‘99–‘03 sample exam.

If a company recognizes revenue earlier than justified under accrual accounting, which of the following best describes the impact on accounts receivable and inventory, respectively? Account Acco untss Receiv Re ceivable able Invento Inve ntory ry A. Over stat ed Over stated stat ed B. O v er s t a te d Unde rstated C. Un U n d er s t at ed O v er s ta te d D . Un Un derstated Unde rstated

Exam Flashback # 3 Source: Question #57 from ‘97–’98 sample exam.

The following are examples of unusual or infrequent items EXCEPT: A. Gains Gai ns or o r losse l ossess from f rom disposa dis posa l of a po rtion rti on of o f a busi ness nes s segmen se gmen t. B. Losses resulting from foreign government expropriation of assets. assets. C. Provisions for environmental remediation. remediation. D. Impairments, write-offs, write-downs, and restructuring restructuring costs.

Exam Flashback # 4 Source: Question #51 from ‘93 actual exam and ‘97–’98 sample exam.

For a material item to be classified as an extraordinary item on the income statement, the item must be: A. esti mated mate d and a nd probable prob able . B. current current and unusual in frequency. frequency. C. probable and and infrequent in nature. D. unusual in nature and infrequent in occurrence. occurrence.

Exam Flashback # 5 Source: Question #52 from ‘93 and ‘96 actual exams and ‘97–‘98 sample exam.

When a co mpan y disc d isconti onti nues nue s an d disp d isposes oses of a n opera o pera tion , the t he actio a ctio n is conside cons idered: red: A. an extr aordina aord ina ry item . B. a prior period period adjustment. adjustment. C. a cumulative effect of a change change in an accounting principle. D. separately and shown net of taxes on the income statement. statement.

©2006 Schweser Study Program

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Exam Flashback # 6 Source: Question #58 from ‘93 and ‘96 actual exams and ‘97–‘98 sample exams.

Which Whic h one on e of the foll owin g is i s a chan ge i n an a n accou a ccou nting nti ng p rin ciple? cip le? A. A chang ch angee from f rom FIFO to L IFO. IFO . B. Recording a prior period adjustment. adjustment. C. A change in the estimated service life of machinery. machinery. D. Recording depreciation expense expense for the first time on machinery purchased five years ago.

Exam Flashback # 7 Source: Question #56 from ‘97–’98 sample exam.

All of t he f ollow ing are general gen eral categor cat egor ies of n onre currin cur ringg items i tems EXCEPT: A. unusua unu suall or infrequ inf requ ent item s. B. discontinue discontinued d operations operations.. C. capitalization of leases. leases. D. accounting changes.

Exam Flashback # 8 Source: Question #58 from 1996 actual exam and ‘97–’98 sample exams.

A fi rm d iscovere isc overed d th at i t ha d used u sed an incorr inc orrect ect acco unting unt ing prin cipl e in 1996. 1996 . On the fir m’s m’s 1997 19 97 fin ancial anc ial stat ements, emen ts, this firm should report the impact of this error as: A. an e xtraord xtr aordina ina ry item. item . B. a nonrecurring nonrecurring item. item. C. part of cost of goods sold. D. a prior period period adjustment.


At the t he time t ime Mar Marsh sh becam b ecam e a subs idiary idi ary of Ross, Ross , Marsh Ma rsh switche swi tched d de preciat prec iation ion of its plan t as sets from fro m su m-ofm-o fthe-years digits to straight-line that was used by Ross. With respect to Marsh, this change was a: A. chan ge i n an a n accou a ccou ntin g estima es tima te. B. change in a reporting entity. entity. C. correction of of an error. error. D. change in accounting principle.

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A NSWERS – E XAM F LASHBACKS 1.

C

The firm must have provided virtually all of the goods or services for which it is to be paid, and the expected cost of providing the service must be measurable. The company must also be able to reasonably estimate the probability of payment.

2.

B

Premature recognition of revenue will result in an artificially high accounts receivable balance. If COGS is measured under the matching principle, then it too will be overstated along with revenue. This results in inventories being understated.

3.

B

Losses resulting from foreign government expropriation of assets are considered to be extraordinary items.

4.

D

Extraordinary items are events that are both unusual and infrequent in occurrence, and material in nature.

5.

D

The income or loss from discontinued operations is reported separately and net of taxes. Past income statements must be restated, separating the income or loss from the discontinued operations.

6. A A ch ange fr om FIFO to LIFO is a ch ange in accounting pr inc iple. 7.

C

The capitalization of leases is not considered a nonrecurring item.

8.

D

Using an incorrect accounting principle is a nonrecurring item that can be remedied with an accounting adjustment so it is reported as a prior period adjustment.

9.

D

Changing depreciation methods is a change in accounting principle.

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E XAM F LASHBACKS Required CFA Institute disclaimer: Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prio r to the curre nt year may not re flect the curre nt cu rricu lum.

Exam Flashback # 1 Source: Question #68 from ‘99–‘03 sample exams.

In the Statement of Cash Flows, which of the following best describes whether interest received and interest paid, respectively, are classified as operating or investing cash flows? Interest Received Interest Paid A. Oper ating Oper ating B. Operating Investing C. Investing Operating D. Investing Investing

Exam Flashback # 2 Source: Question #20 from ‘99 sample exam.

Which of the followin g is reported as a nonca sh f ina ncing t ransact ion on a firm’s statemen t of cash fl ows? A. Repayment of long-ter m de bt. B. Purchase of treasury stock. C. Sale of preferred stock. D. Conversion of bonds payable into common stock.


An a nalyst gathered the foll owin g in formation abou t a company for a fisca l year: Cash paid for land Depreciation expense Cash paid for salaries Cash paid to suppliers Cash collected from customers Cash paid for interest to bondholders Cash collected from the sale of equipment

$30,000 10,000 60,000 40,000 150,000 20,000 75,000

If the company is not subject to income taxes, the net cash flow from operations for the fiscal year is closest to: A. $20,000. B. $30,000. C. $50,000. D. $75,000.

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Exam Flashbacks # 4, 5, & 6 The following questions should be answered according to the provisions of SFAS 95 Statement of Cash Flows and using the following data. Cash payment for interest Retirement of common stock Cash payment to merchandise suppliers Purchase of land Sale of equipment Payments of dividends Cash payment for salaries Cash collection from customers Purchase of equipment

($12) (32) (85) (8) 30 (37) (35) 260 (40)

Exam Flashback # 4 Source: Question #53 from ‘91, ‘94, and ‘96 actual exams and ‘97–‘98 sample exams.

Cash flows from operating activities are: A. $91. B. $128. C. $140. D. $175.


Using the data above, cash flows from investing activities are: A. –$67. B. –$48. C. –$18. D. –$10.


Using the data above, cash flows from financing activities are: A. –$81. B. –$69. C. –$49. D. –$37.

Exam Flashbacks # 7, 8, 9, 10 Use the following data to answer the next four questions. The cash flow data of Palomba Pizza Stores for the year ended December 31, 1991, is as follows: Cash payment of dividends Purchase of land Cash payments for interest Cash payments for salaries Sale of equipment Retirement of common stock Purchase of equipment Cash payments to suppliers Cash collections from customers Cash at beginning of year

$35,000 14,000 10,000 45,000 38,000 25,000 30,000 85,000 250,000 50,000


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What is t he net c ash prov ided by o pera ting ac tivitie s? A. $95,000. B. $100,000. C. $110,000. D. $125,000.


What is t he net c ash prov ided by or used in inve stin g activ ities? A. ($6, 000). B. $0 . C. $6,000. D. $20,000.


What is t he net c ash prov ided by or used in fin anci ng a ctiv ities? A. ($60,000). B. ($24,000). C. $38,000. D. $60,000.


What is Palomb a’s ca sh ba lance a t year end? A. $44,000. B. $50,000. C. $87,000. D. $94,000.


A fi rm h as n ew sales of $3,000, cash expe nses (in clud ing taxes) of $ 1,400 an d depreciat ion of $500. If a ccou nts receivable increase over the period by $400, cash flow from operations equals: A. $1,20 0. B. $1,600. C. $1,700. D. $2,100.

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The following information was available for the Saunders Company for 1990: Net Income Exchanged equity for debt Amor tization o f bond premium Decrease in inventory Increase in accounts payable Retirement of common stock Payment of dividends Depreciation expense

$132 34 18 42 30 45 18 25

What was Saun ders’ net cash f lows from operation s? A. $169. B. $211. C. $245. D. $246.


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A NSWERS – E XAM F LASHBACKS 1. A Both interest paid and interest received are classified as operating cash flows. 2.

D

Conversion of bonds to common stock is an exchange of one security or claim on the firm’s assets for another. It is a noncash transaction.

3.

B

The direct method for calculating CFO can be used to answer the question. Cash collected from customers Cash paid for salaries Cash paid to suppliers Cash paid for interest to bondholders CFO

$150,000 ($60,000 ) ($40,000 ) ($20,000) $30,000

Depreciation expense is a noncash item and is not used in the direct method calculation. Cash paid for land and received from the sale of equipment are components of CFI. 4.

B

The direct method for calculating CFO can be used to answer the question. Cash collection from customers Cash payment to merchandise suppliers Cash payment for salaries Cash payment for interest CFO

5.

C

The components of CFI include cash used to acquire long-term assets (plant, property, and equipment) and cash received from the sale of these assets. CFI is calculated as: Purchase of land Sale of equipment Pu rc ha se of eq ui pme nt CFI

6.

B

260 (85) (35 ) (12 ) 128

$(8 ) 30 ( 40 ) (18 )

The components of CFF include cash used to retire debt, repurchase equity, and to pay dividends. Cash received from new borrowing and equity issues is also included. In this case CFF is calculated as: Retirement of common stock $(32) Payments of dividends (37 ) CFF (69 )

7.

C

The direct method for calculating CFO can be used to answer the question. Cash collection from customers Cash payment to suppliers Cash payment for salaries Cash payment for interest CFO

$250,000 (85,000) (45,000) (10,000) 110,000


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Study Session 7 Cross-Reference to CFA Institute Assigned Reading – White et al., Chapter 3 8. A The components of CFI include cash used to acquire long-term assets (plant, property, and equipment) and cash received from the sale of these assets. CFI is calculated as: Purchase of land Sale of equipment Purchase of equipment CFI 9. A

The components of CFF include cash used to retire debt, repurchase equity, and to pay dividends. Cash received from new borrowing and equity i ssues is also included. In this case CFF is calculated as: Retirement of common stock Payments of dividends CFF

10. D

(14,000) 38,000 (30,000) (6,000)

$(25,000) (35,000) (60,000)

The ending cash balance is equal to the beginning cash balance plus the net cash flow for the period. CFO $110,000 CFI (6,000 ) CFF (60,000 ) Net increase in cash 44,000 Beginning cash 50,000 Ending cash 94,000

11. A Direct method: Step #1

Step #2 Step #3 12. B

Net sales ∆ A/R (use) Cash collections Cash inputs Expenses Cash flow from operations

$3,000 (400 ) 2,600 0 (1,400 ) 1,200

The indirect method for calculating CFO can be used to answer the question. Net income Decrease in inventory Increase in accounts payable Depreciation expense Amor tization o f bond premium CFO

$132 $42 $30 $25 ($18 ) $211

Amor tization of th e bond premium is i ncluded because if a bo nd i s issued at a prem ium, the booked interest expense will be less than the actual cash interest paid. The premium amortization represents the difference between the booked interest expense and the actual cash interest paid; therefore, it must be deducted to fully reflect the cash outlay related to the cost of the debt. Retirement of common stock and payment of dividends are both financing cash flows. The exchange of equity for debt is a noncash transaction. These details are covered in our review of bond discounts and premia in Study Session 10.

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Study Session 8 Cross-Reference to CFA Institute Assigned Reading – Reilly and Brown, Chapter 10

E XAM F LASHBACKS Required CFA Institute disclaimer:Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prio r to the curren t year may not re flect th e current curriculu m.

Exam Flashback # 1 Source: Question #52 from ‘99–‘03 sample exams and question #39 from ‘96 actual exam.

A co mpan y’s current ratio i s 2. 0. If the compa ny uses cash to retire n otes payable that are due within one year, wou ld t his transaction most likely increase or decrease the current ratio and asset turnover ratio, respectively? Current Ratio Asset Turnover Ratio A. Increase Increase B. Increase Decrease C. Decrease Increase D. Decrease Decrease

Exam Flashback # 2 Source: Question #54 from '99, '01–03 sample exams.

Two companies are identical except for substantially different dividend payout ratios. After several years, the company with the lower dividend payout ratio is most likely to have: A. lower st ock pri ce. B. higher debt-to-equity ratio. C. less rapid growth of earnings per share. D. more rapid growth of earnings per share.


An anal yst appl ied the DuPont syst em to the follow ing data for a company: Equity turnover Net profit margin Total asset turnover Dividend payout ratio

4.2 5.5% 2.0 31.8%

The company’s return on equity is closest to: A. 1.3%. B. 11.0%. C. 23.1%. D. 63.6%.


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Study Session 8 Cross-Reference to CFA Institute Assigned Reading – Reilly and Brown, Chapter 10

A NSWERS – E XAM F LASHBACKS 1. A The current ratio will likely increase because there are twice as many current assets as there are liabilities. Thus, for a fixed dollar reduction in both, the proportion of decline in liabilities will be greater than that for the assets. Likewise, for a given level of sales, the asset turnover ratio will increase due to the reduction in assets. If you don’t have good in tuition for this type of question, create a simple example f or yourself. To illustrate, suppose we have a firm with net sa les = 1,000, tota l assets = 50 0, current assets = 200, a nd current liabili ties = 100. T hus, the current ratio = 200 / 100 = 2 and the total asset turnover ratio = 1,000 / 500 = 2. Now consider a reduction in notes payable by 50. Both cash and notes payable fall by 50 as will current assets, current liabilities, and total assets. The new current ratio is 150 / 50 = 3 and the new asset turnover ratio is 1,000 / 450 = 2.2. 2.

D All else equa l, a higher retention r atio wi ll resul t in more rapid e arnings gr owth.

3.

C

ROE is equal to the net profit margin multiplied by the equity turnover ratio. Thus, ROE = 0.055 × 4.2 = 0.231 or 23.1%.


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Study Session 8 Cross-Reference to CFA Institute Assigned Reading – Kieso and Weygandt, Chapter 16

E XAM F LASHBACKS Required CFA Institute disclaimer: Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prio r to the curren t year may not reflect the curren t curricu lum.

Exam Flashback # 1 Source: Question #39 from ‘96 actual exam. A company is d eemed to have a co mplex ca pital s truc ture if it h as: A. potentially dilutive secur ities. B. both preferred and common stock outstanding. C. weighted average cost of capital greater than the rate of return on equity. D. common stock that is less than 20% of its total capital structure.

Exam Flashback # 2 Source: Question #64 from ‘99–‘03 sample exams. An a nalyst gath ered the followin g information abou t a company whos e fi scal year end is December 31: Net income for the year was $10.5 million. Preferred stock dividends of $2 million were paid for the year. Common Stock dividends of $3.5 million were paid for the year. 20 million shares of common stock were outstanding on January 1, 2001. The company issued 6 million new shares of common stock April 1, 2001. The capital structure does not include any potentially dilutive convertible securities, options, warrants, and other contingent securities. The company’s basic earnings per share for 2001 was closest to: A. $0.35. B. $0.37. C. $0.43. D. $0.46.

Exam Flashback # 3 Source: Question #38 from ‘96 actual exam. In computing the weighted average number of shares for the computation of earnings per share, reacquired shares should: A. not be i nclu ded at a ll. B. be excluded from the date of acquisition. C. be included as though they had been outstanding for the entire period. D. be treated the same as stock splits or stock dividends.

Exam Flashback # 4 Source: Question #121 from ‘91 actual exam. Peak Products had two million shares outstanding on December 31, 1997. On March 31, 1998, Peak paid a 10% stock dividend. On June 30, 1998, Peak sold $10 million of 7% convertible debentures, convertible into common at $5 per share. On September 30, 1998, Peak issued and sold 100,000 shares of common stock at par. Basic earnings per share for 1998 will be computed on the following number of shares: A. 2,225,000. B. 2,250,000. C. 3,225,000. D. 3,250,000.


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Exam Flashback # 5, 6, 7 The Wrestling Federation of America, Inc. Capital Structure and Earnings for the Year 1987 Number of Common Shares Outstanding at Year End 2,700,000 Weighted Aver age Number of Common Shares Outst anding During 1987 2,500,000 Weighted Aver age Mark et Pr ice per Common Share Duri ng 1987 $20 300,000 Options Outstanding During 1987: Exercise Price $15 $1,000 Par Value Convertible Bonds Outstanding (December 1983 Issue): Number 10,000 Shares of Common Issuable on Conversion (per Bond) 10 Coupon Rate 5.0% Net Income for 1987 $6,500,000 Tax Rate for 1987 40.0%


Basic earnings per share for 1987 were: A. $2.45. B. $2.57. C. $2.60. D. $2.65.


Using the treasury stock method, how many shares should be added to the denominator to adjust it for the options in calculating diluted earnings per share? A. 50,000. B. 75,000. C. 100,000. D. 225,000.


Diluted earnings per share for 1987 were: A. $2.43. B. $2.48. C. $2.52. D. $2.54.

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A NSWERS – E XAM F LASHBACKS 1. A A complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities. 2. A Basic EPS = (net income – preferred dividends) / weighted average shares outstanding weighted average number of shares outstanding =

basic EPS =

[(20,000,000 ×12) + (6,000,000 ×9)] = 24,500,000 12

10,500,000 – 2,000,000 = $0.347 24,500,000

3.

B

Reacquired shares should be excluded from the computation from the date of reacquisition.

4.

A Note: you are doing basic so don’t consider convertibles.

O ri gi na l sh ar es Stock di vidends New shares Sum

2 ,0 00, 000 (1 2) 200,000 (12) 100,000 (3) 26,700,000/12

= = = =

2 4, 00 0, 000 2,400,000 300,000 2,225,000

$6,500,000 = $2.60 2,500,000

5.

C

basic EPS =

6.

B

⎡ $20–$15 ⎤ ⎢⎣ $20 ⎥⎦ × 300,000 shares = 75,000 shares

7.

C

First determine whether the conversion of the bonds is dilutive or antidilutive. To do this, we first need to calculate the after-tax interest payments, or (interest paid)(1 – tax rate) = ($1,000 × 10,000 × 0.05)(1 – 0.40) = $300,000. The bonds are convertible into 100,000 shares of common stock. $300,000 = $3.00 100,000 The bond conversion is antidilutive because its per share impact is greater than basic EPS of $2.60. $6,500,000 = $2.52 = fully-diluted EPS 2,500,000 + 75,000 Without knowing the bond is antidiluti ve, the calc ulation would be: 6,500,000 + 300,000 = 2.54 2,500,000 + 75,000 +100,000 Keep an eye out for this kind of question on the exam; the obvious answer may not always be the correct one.

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Exam Flashback # 4 Under FIFO, the 1989 retained earnings of Zeta would have been different by: A. ($4, 000). B. $4,000. C. $17,500. D. $32,500.

Exam Flashback # 5 If FIFO had been used for both years, the 1989 cost of goods sold would have changed by: A. ($4, 000). B. ($2,600). C. $1,400. D. $4,000.

Exam Flashback # 6 If FIFO has been used for both years, the 1989 net income would have changed by: A. ($2, 600). B. $1,400. C. $2,600. D. $4,000.

Exam Flashback # 7 Source: Question #62 from ‘94 actual exam and ‘01–‘03 sample exams.

During a period of rising price levels, the financial statements of a company using FIFO instead of LIFO for inventory accounting will show: A. lower total assets an d lower net income. B. lower total assets and higher net income. C. higher total assets and lower net income. D. higher total assets and higher net income.

Exam Flashback # 8 Source: Question #67 from ‘99 sample exam.

During a period of falling price levels, the financial statements of a company using FIFO instead of LIFO f or inventory accounting would show: A. lower total assets an d lower net income. B. lower total assets and higher net income. C. higher total assets and lower net income. D. higher total assets and higher net income.

Exam Flashback # 9 Source: Question #62 from ‘92, ‘96 sample exams.

Which of the following c ombi nati ons environment? Depreciation Method A. stra ight -line B. double declining balance C. double declining balance D. straight-line

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of accounting practices will lead to the highe st repor ted earnings i n an inf lati onar y Inventory Method FIFO LIFO FIFO LIFO



Exam Flashback # 10 Source: Question #53 from ‘97, ‘98 sample exams.

A firm has a cu rren t ratio greater than 1.0. If the firm’s en ding inven tor y is underst ated by $3,000 an d th e beg inning inventory is overstated by $5,000, the f irm’s operating income and the current ratio will be: Net Income Current Ratio A. underst ated by $ 2,000 lower B. overstated by $2,000 lower C. understated by $8,000 lower D. u nderstated by $8,000 higher

Exam Flashback # 11 Source: Question #54 from ‘93, ‘96 actual exams and ‘97,‘98 sample exams.

If net purchases are overstated by $1,000 and ending inventory is overstated by $4,000, then net income is: A. overs tated by $5,000. B. overstated by $3,000. C. overstated by $1,000. D. understated by $4,000.


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B

Ending inventory under LIFO = (400 × $20) + (200 × $22) = $8000 + $4400 = $12,400 Ending inventory under FIFO = (200 × $28) + (300 × $26) + (100 × $24) = $5600 + $7800 + $2400 = $15,800

2.

C

COGS FIFO = COGS LIFO – (ending LIFO reserve – beginning LIFO reserve) COGS FIFO = $16,000 – ($4,000 – $1,500) = $16,000 – $2,500 = $13,500

3.

D

FIFO inventory = LIFO inventory + LIFO reserve $420,000 + 50,000 = $470,000

4.

D

∆ Retained earnings = LIFO reserve (1 – tax rate) ∆Retained earnings = 50,000 (1 – 0.35) = $32,500

5. A ∆ COGS = ∆LIFO reserve If LIFO reserve increases, COGS will fall (–), causing income to rise. 6.

C

∆ Net income = ∆LIFO reserve (1 – tax rate) ∆Net income = 4,000 (1 – 0.35) = $2,600

7.

D

FIFO results in higher inventory values and thus, higher total asset values. FIFO also results in lower COGS and higher net income.

8. A FIFO results in lower inventory values and, thus, lower total asset values. FIFO also results in higher COGS and lower net income. 9. A Remember, FIFO gives you a large inventory and a small COGS, so reported income is greater. 10. C

From the relation COGS = purchases + beginning inv – ending inv we can see that if the beginning i nventory is overstated by $5,000, COGS is overstated by $5,000 and operating income is understated by $5,000. If ending inventory is understated by $3,000, COGS is overstated by $3,000 and operating income is understated by $3,000. Thus, the total understatement of operating income is $5,000 + $3,000 = $8,000. The ending inventory is understated, so current assets are understated and the current ratio (CA/CL) is lower than it otherwise would be if inventory was accounted for properly.

11. B

Beg inventory + purchases – COGS = ending inventory BI (known) + P (over 1,000) – COGS ( +/– ?) = EI (over 4,000) COGS must be understated by 3,000 Sales – COGS = gross income Sales (known) – COGS (under 3,000) = gross income (+/– ?) Gross income must be overstated by 3,000.

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E XAM F LASHBACKS Required CFA Institute disclaimer: Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prio r to the curren t ye ar may not reflect the curre nt cu rricu lum.


Compared with firms that expense costs, firms that capitalize costs can be expected to report: A. high er asset levels a nd lower equity levels. B. lower asset levels and lower equity levels. C. higher asset levels and higher equity levels. D. lower asset levels and higher equity levels.

Exam Flashback # 2 Source: Question #72 from ‘00–’03 sample exams.

Which of the following e xpen ditures to build a new plant i s least likely to be capitalized as property, plant, and equipment? A. Interest cost s du ring co nstr ucti on. B. Freight expenses incurred shipping new machinery to the plant. C. Increases in the fair value of the plant assets during construction. D. Personnel expenses incurred to set up the new machinery before the plant begins operations.

Exam Flashback # 3 Source: Question #60 from ‘93 and ‘96 actual exams and ‘97–’98 sample exams.

The capitalization of interest costs during construction: A. increases f uture n et i ncome. B. increases future depreciation expense. C. decreases net income during the construction phase. D. decreases future depreciation expense.

Exam Flashback # 4 Source: Question #61 from ‘92 and ‘96 actual exams and ‘97-’98 sample exams.

For companies in an expansion phase, capitalization of interest may result in a gain in earnings over an extended period because: A. the amou nt o f interest amor tiza tion will not catch up w ith the amou nt of i nterest capitalized in the cu rren t perio d. B. the average projected expenditures for the period exceed specific borrowings. C. the cost of financing project debt exceeds the cost of equity financing. D. earnings are greater under capitalization than under the expense method over the life of the qualifying asset.


Software development costs incurred before and after a product is proven economically feasible are: A. expensed both befo re and after. B. capitalized both before and after. C. expensed before and capitalized after. D. capitalized before and expensed after.

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C

Capitalization causes asset levels to increase, which in turn increases equity levels.

2.

C

Under U.S. GAAP, increases in the fair value of the plant assets duri ng construction are not capitalized. However, under IASB standards firms may report plant, property and equipment at fair value less accumulated depreciation. There appears to be no clear answer to this question. However, when faced with this dilemma, focus on two possible solutions: (1) review the question for a clearer understanding—in this case, the italicized words least likely are one clarifying clue, and (2) if the conflict arises due to diff erences in U.S. GAAP and IASB GAAP, favor the response consistent with U.S. GAAP.

3.

B

The capitalization of interest costs will increase the book value of the asset and fu ture depreciation expense. This will result in high er i ncom e du rin g the constr ucti on phase and l ower future net income.

4. A For firms in an expansion phase, and therefore incurring large amounts of investment outlays and financing, the amount of interest amortization will not likely catch up with the amount of interest capitalized in the current period for an extended period of time. 5.

C All c ompu ter soft ware deve lopment costs in curred t o est abli sh the tec hnol ogical o r economic f easi bili ty of software should be expensed (e.g., R&D). Subsequent costs may be capitalized as part of inventory.

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E XAM F LASHBACKS Required CFA Institute disclaimer: Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prio r to the curren t year may not reflect the curren t curricu lum.

Exam Flashback # 1 Source: Question #64 from ‘94, ‘96 actual exams and ‘97, ‘98 sample exams.

Which on e of the foll owin g st atements about straight-l ine depr ecia tion is TRUE ? Straight-line depreciation: A. resu lts in a decr easi ng r etur n on equity over the asse t’s life. B. introduces a built-in increase in return on investment over the asset’s life. C. recognizes the increasing rate of obsolescence of an asset with the passage of time. D. results in higher total tax payments over the life of an asset than accelerated depreciation.


To account for the purchase of a machine, a company may use either straight-line (SL) depreciation or the sum-of-the-years’digits depreciation (SYD). Return on investment for the machine will: A. ini tial ly b e hi gher und er S YD t han under S L. B. remain constant under SL. C. decrease over time under SLD. D. initially be higher under SL than under SYD.


The Haynes Company takes a full year’s depreciation expense in the year of an asset’s acquisition and no depreciation in the year of disposal. The following information is given on a depreciable asset: Acqu isition date Estimated useful life Residual value Cost Accu mula ted deprecia tion as of 1 2/31/89

1/1/ 89 5 years $20,000 $110,000 $30, 000

Assu ming the company uses the same method i n 19 90, what wi ll be the de preciation expe nse for 1990? A. $18,000. B. $22,000. C. $24,000. D. $30,000.

Exam Flashback # 4 Source: Question #75 from ‘00, ‘01, ‘02, ‘03 sample exams.

An analyst gathered the f ollow ing inf orma tion about a fixed asse t pu rcha se by a comp any: Purchase price Estimated useful life Estimated salvage value

$12,000,000 5 years $2,000,000

Using the double-declining-balance depreciation method, the company’s depreciation expense in year 2 will be closest to: A. $2,000,000. B. $2,400,000. C. $2,880,000. D. $7,680,000.


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A ma chin e is purchas ed f or $ 3,000 an d ha s an estimated u sefu l li fe o f five years. Its s alva ge value is esti mated to be $550. Using double-declining balance, the depreciation charge for year three is: A. $360.00. B. $432.00. C. $500.00. D. $720.00.


A fi rm u sing stra ight-li ne d epreciation reports gross investmen t in fixed a ssets of $80 million , ac cumu lated d epreciation of $45 million, and annual depreciation expense of $5 million. The approximate average age of the fi xed assets is: A. 7 years. B. 9 years. C. 15 years. D. 16 years.


Which of the f ollow ing statemen ts about impa irment and appreciatio n of the value of long-lived asse ts is TRUE ? Managers: A. may recognize gain s an d lo sses due to i mpaired assets o nly when those as sets are sold . B. have considerable discretion about the timing and amount of recognized increase in value of appreciated assets. C. have considerable discretion about the timing and amount of impairment recognition for assets the firm intends to keep. D. may write-up the value of a previously-impaired asset to the original book value prior to impairment, if the asset recovers its value.

Exam Flashback # 8 Source: Question #65 from ‘87, ‘88, ‘92, ‘96 actual exams.

Which of the foll owin g statem ents abou t ac coun ting pract ices is TRUE ? A. FIFO resu lts in more cons ervativ e ea rnings figures , except during deflati onary periods . B. Capitalization of interest results in higher earnings over the life of an asset. C. Interest may be capitalized for some assets intended for use by the firm, but not for assets intended to be sold. D. In the absence of a decision to abandon or dispose of assets at a loss, the timing and amount of any write-down are largely discretionary.


In 2001, Baxter Company owned machinery that became permanently impaired. As of December 31, 2001, the machinery had a book value of $800,000 and a market value of $100,000. Baxter also owned a warehouse that, as of December 31, 2001, had a book value of $1,200,000 and a market value of $2,500,000. Baxter: A. must recognize both the l oss on the m achi ner y and t he gain on t he warehouse in 2001. B. may recognize the loss on the machinery and the gain on the warehouse in 2001 or in later years. C. must recognize the loss on the machinery in 2001, but may not recognize the gain on the warehouse until it is sold. D. may recognize the loss on the machinery in 2001 or in later years, but may not recognize the gain on the warehouse until it is sold.

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B

Straight-line depreciation will result in lower book values over time. Even with constant earnings, ROA will increase over time.

2.

D

Initially SYD depreciation is larger than SL depreciation. This will result in lower earnings and ROA for the SYD in the early years of investment.

3.

C

30,000 is one year’s depreciation. Straight-line depreciation = ( 110,000 – 20,000) / 5 = $18,000 Double declining balance = (110,000 – 0) × (2 / 5) = $44,000 Sum of years’ digits = (110,000 – 20,000) × (5 / 15) = $30,000 Therefore the firm is using SYD. So in the second year where n = 4, the depreciation is: (4 / 15) × (110,000 – 20,000) = $24,000

4.

C

DDB = (cost – accumulated depreciation) × (2 / life) DDB1 = ($12,000,000 – 0) × (2 / 5) = $4,800,000 DDB2 = ($12,000,000 – $4,800,000) × (2 / 5) = $2,880,000

5.

B

Double declining balance = (cost - accumulated depreciation)(2 / years) Year 1: 3,000(0. 4) = $1,200 Year 2: (3,0 00 – 1,200)(0.4) = $720 Year 3: (3,0 00 – 1,920)(0.4) = $432

6.

B Averag e ag e = (ac cumu lated depreciation ) / (deprec iati on expense) = 45 / 5 = 9 years The average age equation can only be used for firms employing straight-line depreciation.

7.

C

Managers have considerable discretion about the timing and amount of impairment recognition for assets the firm intends to keep. Under U.S. GAAP, firms are not allowed to write-up the value of assets when they appreciate, even if the asset was previously impaired.

8.

D

The response to A is false—LIFO results in more conservative income. COGS is higher and income is lower under LIFO. In foil B, interest capitalization converts current interest expense to future depreciation expense. Foil C is nonsensical. D is true. Management holds a great deal of discretionary power over the decisions regarding impairment recognition.

9.

C

Baxter must recognize the loss on the machinery in 2001 but may not recognize the gain on the warehouse until it is sold. You may be tempted to pick D because of the managerial discretion allowed in the impairment process. However, conservative accounting practices require write-downs as soon as the impairment is recognized, so choice C is the better response.


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E XAM F LASHBACKS Required CFA Institute disclaimer: Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prio r to the curre nt year may not re flect the curre nt cu rricu lum.

Exam Flashback # 1 Source: Question #66 from ‘99-’03 sample exams.

When analyzing a company’s lev erag e and l iquidi ty, an analyst shou ld consider de ferred tax liabili ties on a company’s balance sheet: A. as equity. B. as long-term debt. C. as short-term debt. D. on a case-by-case basis.

Exam Flashback # 2 Source: Question #66 from ‘93 and ‘96 actual exams, and ‘97-’98 sample exams.

Which of the following s tatements about de ferred taxes is tr ue? Defe rred taxes: A. will decrea se only when a cash pay ment is m ade. B. are not found on the liability side of the balance sheet. C. result from permanent differences between taxable and reported earnings. D. that arise from depreciation of a particular asset will ultimately reduce to zero as the item is depreciated.


When a defer red tax liabili ty a ccou nt “rever ses”: A. the actu al t ax b ill is l ower than the expe nse in the income stat emen t. B. the actual tax paid is the same as the expense in the income statement. C. cash outflow is increased by the amount of the reversal. D. cash outflow is lessened by the amount of the reversal.

Exam Flashback # 4 Source: Question #63 from ‘01-’03 sample exams.

Delta Corp., a highly profitable company, purchased a new asset on January 1, 2001, for $1,000,000. The following information applies to the asset: Depreciated straight-line over 10 years with no salvage value Three-year MACRS depreciation class, with first year MACRS factor = 0.333 Tax rate of 40% The effect of the asset purchase on Delta’s deferred tax liability for 2001 is closest to a: A. $233,000 decr ease. B. $93,200 decrease. C. $93,200 increase. D. $233,000 increase. Professor’s Note: MACRS is an accelerated depreciation schedule permitted for tax purposes. The factor of 0.333 just means that first y ear depreciatio n is 33.3 percent.

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Exam Flashback # 5 Source: Question #24 from ‘92 and ‘96 actual exams and ‘97-’98 sample exams.

White Com pany ha s a temporar y di fference be tween the tax liab ility it report ed to the government and the tax liability that appears on its financial statement. There was a deferred tax liability of $30.6 million. Under Statement of Financial Accounti ng St andards 96, an increas e in the tax rate wo uld have whic h of the f ollow ing impacts on deferre d ta xes and net income: Deferred Taxes Net Income A. Increase No ef fect B. Increase Decrease C. No effect No effect D. No effect Decrease


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D

If deferred liabilities are expected to reverse in the future, they are best classified as liabilities. If, however, they are not expected to reverse in the future, they are best classified as equity.

2.

D A part icular asset has a finite useful life and, by definition, any tax differences for any one asset will reverse by the end of the asset’s useful life.

3.

C A deferred tax liabili ty is c reated w hen actu al cash tax payment s to the gover nmen t are le ss than the tax expe nse reported on the income statement (e.g., depreciation is higher on the tax statement and lower on the income statement, implying that taxable income is lower on the tax statement relative to the income statement). When this liability reverses, cash is being paid to the government in the amount of the reversal.

4.

C

MACRS depreciation = $1,000,000 × 0.333 = $333,000 SL depreciation = $1,000,000 / 10 = $100,000 Change in deferred tax liability = (MACRS depreciation – SL depreciation) × tax rate = ($333,000 – $100,000) × 0.40 = $93,200

5.

B

If the tax rate increases, deferred tax liabilities and the current tax expense increase. As a result , net income decrease s.


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E XAM F LASHBACKS Required CFA Institute disclaimer: Due to CFA curriculum changes from year to year, published sample exam questions and guideline answe rs p rior to the current yea r may not refl ect the curre nt c urri culum.


Empire Corporation issues a zero-coupon bond with $100,000 face value, a 5-year maturity, and a market rate of 8 percent. Interest on corporate bonds is normally paid semiannually. In the liability section of Empire’s balance sheet, the proceeds from selling the zero-coupon bond immediately after the issuance will be closest to: A. $60,000. B. $67,556. C. $68,058. D. $100,000.

Exam Flashback # 2 Source: Question #88 from ‘93 and ‘96 actual exams.

Baldwin Assets holds a $100,000 non-interest-bearing note that is due in 10 years. Baldwin has a return on equity of 18%, a return on assets of 12%, and a borrowing rate of 14% (assume an annual pay bond). In Baldwin’s income statement, the interest income from the note is: A. $0. B. $3,438. C. $3,780. D. $3,864.


A firm has va riable- rate lon g-te rm debt o utst anding. All else equal, w hat effects will a r ise in i nter est r ates have on the firm’s debt-to-equity and net income? Debt-to-Equity Ratio Net Income A. Decrease Decr ease B. No change Increase C. Decrease Increase D. Increase Decrease

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B

The present value of the zero-coupon bond is calculated as: N = 5×2 =10; I/Y = 8/2 = 4; FV = 100,000. There is no PMT. CPT → PV = $67,556

2.

C

The loan value (or loan PV) is calculated as follows, assuming annual payments: FV = 100,000; N = 10; I/Y = 14; CPT → PV = $26,974 Income = implied interest rate times PV (0.14)($26,974) = $3,776 ≈ 3,780 Note the other two answers follow directly from the other data given: (0.18)(19,106) = $3,439 and (0.12)(32,197) = $3,864

3.

D

This is a diff icult question. First, future net income will decline due to the rise in interest expense (cash interest expense on a variable rate loan will ri se as market interest rates rise). That is the easy part. What about the debt-toequity (D/E) ratio? Since earnings are down, retained earnings will also be lower in the future so the D/E ratio should increase (because equity has declined). Note that this assumes that expected increases in future borrowing are unchanged. The value of debt on the balance sheet remains unchanged.

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E XAM F LASHBACKS Required CFA Institute disclaimer: Due to CFA curriculum changes from year to year, published sample exam questions and guideline answers prio r to the curren t ye ar may not reflect the curre nt cu rricu lum.


On January 1, a company entered into a capital lease resulting in an obligation of $10,000 being recorded on the balance sheet. The lessor’s implicit interest rate wa s 12 percent. At the end of the first year of the lease, the cash flow from financing activities section of the lessee’s statement of cash flows showed a use of cash of $1,300 applicable to the lease. The amount the company paid the lessor in the first year of the lease was closest to: A. $1,200. B. $1,300. C. $2,500. D. $10,000.

Exam Flashback # 2 Source: Question #55 from ‘99–’03 sample exams (revised).

An a nalyst should cons ider whet her a co mpan y acquired as sets through a capital leas e or an o pera ting le ase beca use the company may structure: A. oper atin g leases to look like ca pita l leases to enhance the comp any’s profi tabi lity ratio s du ring th e early year s of the asset’s life. B. operating leases to look like capital leases to enhance the company’s liquidity ratios. C. capital leases to look like operating leases to enhance the company’s leverage ratios. D. capital leases to look like operating leases to enhance the company’s receivables turnover ratio.


A lease is most likely to be classified a s an oper ating lease if the: A. lease co ntai ns a ba rgain purchase op tion . B. collectiblity of the lease payments by the lessor is unpredictable. C. term of the lease is more than 75% of the estimated economic life of the leased property. D. present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property.


Which of the followin g is NOT an example of off-balance sheet financing: A. Parti cipatin g in joint ventures. B. Using take-or-pay arrangements. C. Issuing convertible preferred stock. D. Selling accounts receivable to an unrelated party with limited recourse.


Firms that sell their accounts receivable and use the proceeds to reduce their debt distort the pattern of cash flow from: A. financ ing, but this distortion is offset by a simi lar distortion in the cash flow from operation s, s o no adjustment is necessary when calculating the firm’s financial ratios. B. financing, so analysts should switch the amount of receivables sold from current liabilities to long-term debt when calculating the firm’s financial ratios. C. operations, but this distortion is offset by a similar distortion in the cash flow from financing, so no adjustment is necessary when calculating the firm’s financial ratios. D. operations, so analysts should reverse the sale by increasing the firm’s receivables and treating the proceeds of the sale as debt in computing the firm’s financial ratios.

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C

In a capital lease part of the lease payment is interest (CFO) and the remainder is pr incipal (CFF). The question states that the CFF part is $1,300. Interest is calculated as $10,000 × 0.12 = $1,200. The total payment is $1,300 + $1,200 = $2,500.

2.

C

If you restructure a capital lease to look like an operating lease, the leasehold liability is removed from the balance sheet and the debt-to-equity ratio will improve. Profitability ratios will not improve under a capital lease because the sum of interest expense plus depreciation will exceed the lease payment early in the life of the lease.

3.

B

If the collectiblity of the lease payments by the lessor is unpredictable, the lease is classified as an operating lease.

4.

C

Convertible preferred stock issues are reported on the balance sheet.

5.

D

The sale of receivables artificially reduces the receivables balance and short-term borrowings and increases cash from operations in the period of sale. For analytical purposes, the receivables and short-term debt should be added back to the book value balances.

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Past CFA Level 1 FRA Qs

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