Your Cheat Sheet to… CFA Level I: Financial Reporting and Analysis

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By Sophie

The Cheat Sheet articles are a series of articles, each focusing on one specific topic area of the CFA exam for one specific CFA level. In each Cheat Sheet article, we will cover the basics of what you need to know before diving into the material – what it’s about in a nutshell, how significant is it in the CFA exams, real-life applications, and tips for the CFA exams. You should aim to read each relevant Cheat Sheet article before you start studying the topic area to get you to a flying start.

Financial Reporting and Analysis is one of the largest hurdles in the CFA exams, especially for Level I and Level II. This large topic area covers all manners of financial reporting techniques, conventions and policies, with an emphasis on comparability between companies. This is a big topic area, so make sure you pay extra attention to it!


What is the weighting of this topic in the CFA exams?

Financial Reporting and Analysis has a whopping 20% weighting in the CFA Level I exams – the largest of all topic areas. It’s a big-hitter in CFA Levels I and II, but is dropped off at Level III. This is one of the unmissable topic areas – key to passing Levels I and II, and therefore key to the entire CFA program.

If you’re still not convinced, 20% weighting in CFA Level I also means that you’ll encounter, on average, 48 questions focusing on Financial Reporting and Analysis.


What is Financial Reporting and Analysis about, in a nutshell?

The Financial Reporting and Analysis readings for CFA Level I, in a nutshell, teach you:

  • How to read and understand each component of the financial statements
  • How to assess whether these reported financials are fair, and if not, how to make adjustments to these numbers for the purpose of your valuation analysis
  • How to independently value an asset or a company for investment purposes

This topic is split into 13 (!) readings:

  1. Financial Statement Analysis: An Introduction discusses the scope and framework of financial statement analysis, introduces the major financial statements as a starting point.
  2. Financial Reporting Mechanics illustrates the accounting process and systems, how we can use financial statements in security analysis.
  3. Financial Reporting Standards mainly focuses on the IFRS framework and its comparison with US GAAP. 
  4. Understanding Income Statements looks at general principles of revenue and expense recognition, non-recurring items and EPS in the income statements that you’ll come across in financial analysis. 
  5. Understanding Balance Sheets walks through each component of the balance sheet in detail: assets (current and long term), liabilities (current and long term)  and equity.
  6. Understanding Cash Flow Statements explains the connection of cash flow to income and balance sheet, while introducing a myriad of ratios for analysis which serves as an exam question favorite. 
  7. Financial Analysis Techniques is a broader, more theoretical chapter which gives an overview of the tools an analyst could use in analyzing a company.
  8. Inventories compares and contrasts the key inventory valuation methods (LIFO, FIFO, etc) and how it impacts inventory ratios and financial analysis. 
  9. Long-lived Assets reviews the treatment of long term assets from acquisition, depreciation/amortisation, revaluation, impairment and derecognition of these assets, with an introduction to finance versus operating leases which you should know the difference of. 
  10. Income Taxes is a section you need to master, as many exam questions tests your knowledge of the difference between taxable and accounting profit, and what contributes to a deferred tax liability or asset. 
  11. Non-current (Long Term) Liabilities looks at the accounting, presentation and disclosure of long-term debt and introduces leverage and coverage ratios in evaluating solvency of a company. 
  12. Financial Reporting Quality discusses conservative and aggressive accounting practices and some tips on how to detect them.
  13. Financial Statement Analysis: Applications is a chapter covering a few working examples of typical analyst adjustments to financial reports in investment analysis, tying together the knowledge learned from this topic area into everyday applications. 

Why should I care about this in real life?

The whole point of becoming a CFA charterholder is, in essence, to be able to make or help others make sound investment decisions. And you have to understand your potential investment to be able to make a good decision about it. FRA is a key part in that – learning to understand how well (or badly) a company is doing by scrutinising their financial statements.

Investment decisions are nothing without understanding, assessing and adjusting your view of reported financial statements (i.e. what they’re saying) to build a full picture of your valuation and investment analysis (i.e. what is truly happening). This topic area is bread-and-butter for a wide range of financial roles, including buy and sell-side analysts, asset managers, wealth managers and investment bankers.


Any tips for the exam I should know about?

Unfortunately there is no shortcut to mastering FRA – you’ll have to set aside adequate time in your study plan to learn this topic area thoroughly. As mentioned earlier in the article, there is a lot of testable material in the vast amount of readings in the CFA exams. Not only does the FRA have a 20% weighting in the CFA Level I exams but FRA can sometimes be weaved into other topic area questions. This topic isn’t a fringe one, so don’t skirt around it – tackle it head-on.

Here are some tips to get you fighting-fit in FRA:

  • Make practice front and center of your FRA plan. Lots of practice questions help solidify your understanding, so make sure you line them up. Try to attempt all the end-of-chapter questions to get used to the breadth of items that can crop up in the actual exam. FRA questions can require a lot of reading and calculation so time management and answering speed will be crucial as well.
  • Videos can help a lot. There are likely a lot of confusing concepts or calculations that you may get lost in repeatedly. A good way to break the cycle of confusion is to simply spend a few minutes on YouTube. Find an explanation of the specific concept – sometimes all you need is someone to take you through one example.
  • Pay attention to IFRS and GAAP. ‘IFRS vs GAAP’ questions are a favorite in the CFA exams, so make notes on what the differences and similarities are between the two accounting standards and make sure you have them memorized.
  • Build a 3-statement financial model. To truly understand FRA you’ll need to master the balance sheet, income statement and cash flow statement. A good way to achieve this is to build a simple 3-statement financial model – not nearly as intimidating as it sounds. Pick your favourite company, download their financial reports and get started – preferably with a financial modelling book (we recommend Financial and Managerial Accounting by Warren, Reeve & Duchac)


How does Financial Reporting and Analysis get tested?

FRA questions can come in calculation-based or qualitative versions. Below is an example of a qualitative-based question that tests your understanding of the theory behind it. For these kinds of questions, quite often you’ll either know the answer, or completely have no clue.

Compared to using a finance lease, a lessee that uses an operating lease will most likely report higher:
       
A. current liabilities
B. cash
C. assets

The correct answer is B.

Under a finance (capital) lease, assets and liability (lease payable) are increased by the present value of lease payments owed. In contrast, no assets or liabilities are recorded under an operating lease.

Under a finance lease, cash payment is divided into two parts: interest expense (as CFO) and reduction of liability (as CFF). Hence, CFO under finance lease is always higher than CFO under operating lease throughout the lease because the entire payment is classified under CFO outflow under an operating lease.

Regardless of the lease classification, total cashflow is the same for the lessee under both lease types.

Alternatively, here is a common calculation-based question that requires you to know the formulae and perform a quick and accurate calculation to obtain your answer within the time limit:

A company has 1 million EUR 1 common shares and 2 million EUR 1 5% preferred shares in circulation at 1st January 2016. It carries out a public issue of 600,000 new common shares on 1st May 2016. Its net income for the year is EUR 4 million and it pays a EUR 1,500,000 dividend for common shares.

The earnings per share for the year ended December 31 2016 is closest to:

  1. A. EUR 1.71
    B. EUR 2.44
    C. EUR 2.79
The correct answer here is C.

Note that common stock dividends are not subtracted from net income when calculating EPS.

EPS = (Net income – preferred dividends) / (Weighted average number of common shares outstanding)
          = (4,000,000 – (0.05 x EUR 1 x 2,000,000) ) / (1,000,000 + (8/12) x 600,000)
          = EUR 2.7857


More Cheat Sheet articles will be published over the coming weeks. Get ahead of other CFA candidates by: 

Zee Tan
Author: Zee Tan

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