CFA Level I

Question #1 of 18 Question ID: 1210918

The fundamental qualitative characteristics of financial statements as described by the IASB conceptual framework least likely
include:

A) relevance.

B) reliability.
C) faithful representation.

Explanation

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)

Question #2 of 18 Question ID: 1210922

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.

Explanation

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)

Question #3 of 18 Question ID: 1210920

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

Explanation

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))

Question #4 of 18 Question ID: 1210924

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%.

Explanation

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)

Question #5 of 18 Question ID: 1210919

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.

Explanation

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)

Question #6 of 18 Question ID: 1210925

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.

Explanation

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)

Question #7 of 18 Question ID: 1210933

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.

Explanation

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)
Question #8 of 18 Question ID: 1210927

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.

Explanation

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)

Question #9 of 18 Question ID: 1210931

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.

Explanation

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)

Question #10 of 18 Question ID: 1210928

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.

Explanation

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)
Question #11 of 18 Question ID: 1210930

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.

Explanation

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)

Question #12 of 18 Question ID: 1210926

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.

Explanation

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)

Question #13 of 18 Question ID: 1210934

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.

Explanation

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)

Question #14 of 18 Question ID: 1210929

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.

Explanation

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)

Question #15 of 18 Question ID: 1210932

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.

Explanation

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)

Question #16 of 18 Question ID: 1210923

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.

Explanation

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, Module 21.5, LOS 21.i)

Question #17 of 18 Question ID: 1210935

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.

Explanation

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)

Question #18 of 18 Question ID: 1210921

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.

Explanation

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)