CFA CFA Level 2 adjusted CFO

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Posts
• vincentt
Participant
• CFA Level 3
22

Couldn’t get my head around this adjusted CFO in the equity topic to calculate the P/CF ratio.

Since IFRS allows interest expense to be classified under CFO or CFF and US GAAP under CFO, we have to adjust CFO by adding back the after-tax interest cost.

Adjusted CFO = CFO + [ net cash interest outflow x (1 – tax rate) ]

This adjustment seems to be for US GAAP as interest expense is deducted from CFO. (Please correct me if i’m wrong.)

However, there’s one question in schweser asking to calculate P/adjusted CF but the right answer includes deduction of non recurring expense.

How would I know when to include nonrecurring expense as the formula given in the syllabus don’t seem to include that.

• Zee Tan
Keymaster
• CFA Charterholder
7

The images are not showing – probably because you’re using your private dropbox account.

http://imgur.com/ might work better.

• 5

• vincentt
Participant
• CFA Level 3
5

@-) is this the kind of question I should be expecting in the exam? In terms of the level of trickiness?

• vincentt
Participant
• CFA Level 3
5

thanks @sophie , I actually understand that like for like comparison. My confusion is on which is the right thing to do usually (at least for the CFA exam):

1. to adjust US GAAP to match IFRS
or
2. to adjust IFRS to match US GAAP

Hence, I was asking about the formula given in the book (though no further info given), trying to analyse if the + sign really mean something which could tell which framework should be adjusted.

But apart from that, I entirely understand the concept of like-for-like comparison thanks guys!

• 4

Ok @vincentt, I may not have the full context here as it refers to a specific practice question and your question is not entirely clear, which is understandable as you wanted to avoid having to add the whole shebang.

As you rightly say on the treatment of interest expense in IFRS vs. US GAAP, you need to adjust the CFO to compare 2 companies under different accounting regimes. The adjusted CFO just adds back interest expense to a company reporting under GAAP to make a GAAP company’s CFO equivalent to a competitors CFO that reports under IFRS (assuming it’s classified under CFF in this case).

I don’t have the details of the question, but the principle of adjusting CFO is to be able to “take out the noise” in the operating cashflow, so to speak, to see the “true” operating cashflow generated from the underlying business (not how it is financed). So the impact of non recurring, one-off items needs to be excluded. I don’t have further info to comment on the rest I’m afraid.

• 4

My answer would be 17. There is no need to add after tax interest expense just because all other companies are also reporting under US GAAP. The only thing you need to adjust is the non-recurring expense, so it’s comparable to other US GAAP companies in other industries. Am I right?

It’s all about comparing apples with apples. So it’s a trick question if you memorize blindly!

• 4

I believe that in this exercise you are not supposed to adjust for the interest expense precisely because the statements are already in GAAP.

IF they were under IFRS and the interest was put in financing activities, THEN you would adjust that as well in order to compare to US GAAP companies (which must put it in operating).

Since here it is already done in GAAP, you adjust just for non-recurring activities.

Hope this makes sense!!

• 4

perhaps @vincentt. But after all these practice questions, you’ll know all the tricks ðŸ™‚

• vincentt
Participant
• CFA Level 3
4

@lulu123 but that’s the confusion I have over the formula given.

Adjusted CFO = CFO + interest expense after-tax

Under IFRS, if interest was put in CFF, and to adjust CFO wouldn’t it be right to deduct interest from CFO rather than adding back (or does adding back includes the +/- sign as well) ?

• 3

@vincentt if you include references to the material you’re referring to for future questions that would help us zero in on a great answer ðŸ™‚

I need further context to help for this question but hopefully @Diya’s answer helps.

• vincentt
Participant
• CFA Level 3
3

Spot on @Diya it’s reading 35 Q20! Got you on #1 (have to exclude nonrecurring operating expenses if it’s provided then), as for #2 i don’t quite get the concept.

If interest expense(IFRS) is classified under CFF, wouldn’t it be right to deduct rather than add to the CFO since it’s a cash outflow? Or does the ‘outflow’ already assume the negative sign?

adjusted CFO = CFO + (- interest expense after tax) ?

• vincentt
Participant
• CFA Level 3
3

@sophie if our assumption is true then the question in schweser might not be as it’s US GAAP and does not take after-tax interest expense into account.

Here’s the question:

Clementi requests that Fischer calculate the P/CFO for lester’s, using adjusted cash flow from operations for cash flow from comparison with other companies. The adjusted P/CFO for Lester’s is closest to:

15
17
19

• vincentt
Participant
• CFA Level 3
3

Adjusted CFO = CFO + nonrecurring item (after tax) + interest expense (after tax)
= \$1,497,442,000 + \$139,870,000 (1 – 0.37) + \$231,968,000 (1 – 0.37)
= \$1,731,699,940

Adjusted CFO per share = \$1,731,699,940 / 631,643,000 = \$2.74

Adjusted P/CF = \$42.10 / \$2.73 = \$15.42

hence the closest answer is A: 15.

The answer in the book is B: 17.

What they did was just to add back nonrecurring item and did not include the interest expense which is why I don’t quite understand the notes mentioned in page 173 (which is the paragraph i quoted few posts above).

• 2

I think you are talking about question 20 for chapter 35? Hopefully I’m right because my answer is based on that.

1) for the nonrecurring cash flow component
2) for the difference in accounting standard which can be adjusted by
[(net cash interest outflow)(1-tax rate)] when an IFRS company decides to classify
their interest as CFF

Refer to page 173 of chapter 35 the first paragraph talks about adjusting for non-recurring cash flow.

• 2

The question now is, does it add back to US GAAP or IFRS’s CFO?

Logically, I would think they should add it back to US GAAP’s CFO especially when IFRS classify interest expense under CFF (so both CFO are clean, without interest expense charges).

Yup this is it. Same as what I mentioned previously.

As you rightly say on the treatment of interest expense in IFRS vs. US GAAP, you need to adjust the CFO to compare 2 companies under different accounting regimes. The adjusted CFO just adds back interest expense to a company reporting under GAAP to make a GAAP company’s CFO equivalent to a competitor’s CFO that reports under IFRS (assuming it’s classified under CFF in this case).

• vincentt
Participant
• CFA Level 3
2

@zee u’re quick! fixed that now.

• 2

@Sophie thanks for the clarification. Or I’d be adding the interest adjustment incorrectly! #-o

• vincentt
Participant
• CFA Level 3
2

@diya yeah that’s the thing, schweser did not mention adding back after-tax interest expense to US GAAP or IFRS’s CFO. But logically it should be deducting from US GAAP’s or adding back to IFRS.

If that assumption is true, then the answer to that question might not be correct as it’s US GAAP and did not add back the after-tax interest expense to the CFO but only the nonrecurring.

• vincentt
Participant
• CFA Level 3
1

@christine would definitely do that the next time, just thought not everyone is using schweser ðŸ™‚

• vincentt
Participant
• CFA Level 3
1

@sophie probably the question i’m asking is more to do with the concept of adjusting than the specific question now.

In schweser notes page 173 of book 3:

Another proxy for cash flow from operations (CFO) from the cash flow statement. CFO is often adjusted for non-recurring cash flows. Also, IFRS allows interest expense to be classified as operating cash flow or financing cash flow. US GAAP requires interest expense to be classified as operating cash flow. Therefore, analysts often adjust CFO by adding back the after-tax interest cost and call it adjusted CFO.

The question now is, does it add back to US GAAP or IFRS’s CFO?

Logically, I would think they should add it back to US GAAP’s CFO especially when IFRS classify interest expense under CFF (so both CFO are clean, without interest expense charges).

Or to look at it the other way, IFRS (only those who classify interest expense under CFF) should move the charges of after-tax interest expense from CFF to CFO so it could be compared with US GAAP’s.

But schweser notes did not really specify under which framework do we add back.

• 1

Ah, perhaps you’re getting confused with the signs +-. Think of it as absolute would be less confusing.

If under IFRS, interest was put in CFF, and you want to adjust IFRS’ CFO number to match US GAAP’s methodology, then you have to remove interest expense from CFF and place it in CFO. So in this case, you add back interest expense in CFF (because you want to ‘neutralise’ the effect of it here) and shift it to IFRS CFO, by deducting interest expense from CFO.

We have discussed the case of adjusting US GAAP CFO to compare like-with-like with IFRS CFO (assuming interest expense classified in CFF), whereby you adjust US GAAP CFO by adding back interest expense.

I suppose what @lulu123 meant by adjusting is comparing like with like. Try not to think of it as hard formula per se, but the principle behind. Hope this helps @vincentt!

• 1

Sure I get what you mean @vincentt. And thats not over analysing. Normally the question will let you know what they want to compare, hence you can apply the relevant method. If I have to pick one, usually it is method 1.