Mock Exam B: Session 1 Answers

Question 1
L1ET-MS05-ME0001-1604
Rajiv Patel is planning on leaving his employer. He has provided two-week notice to his
supervisor, who reminded Patel that he signed a nonsolicitation agreement with his
employer. Under that agreement, he may not solicit clients to join his new firm for at
least one year after his employment ends. Patel has an account with a professional
social media website on which many of his clients have joined his network. Neither his
employer nor Patel has announced his planned departure to any clients. When is it
appropriate for Patel to update his employment status on the social network's profile?
a) He may update his profile immediately.
b) In two weeks when his employment officially ends.
c) He may not update his profile until the one-year anniversary of his
departure.
Explanation
Standard IV(A) requires Patel to place his employer's interest ahead of his own. Patel
may update his social network profiles as soon as his resignation becomes effective, but
must refrain from contacting former clients if required by his non-solicitation
agreement.
Question 2
L1ET-AS05-ME0002_2212
Hebert DePlaine, CFA, is a portfolio manager who directs most of his commission
business to Gamma Brokers. DePlaine is active with a charity that raises funds for
terminally ill children. As a gesture of gratitude for his business, Gamma makes a $1,000
donation in DePlaine's name to the charity. Because he does not benefit financially from
the gift, DePlaine decides not to disclose the gift to his supervisor. Has DePlaine violated
the Standards of Professional Conduct?
a) Yes, because the donation is greater than $200.
b) Yes, because he received a nonfinancial benefit.
c) No, because he did not benefit personally from the gift.
Explanation
DePlaine is required to disclose to his supervisor any gift that could potentially
compromise his independence and objectivity, whether the gift is in cash or in kind.
While the Standards do not specify the size of gift considered larger than "token,"
$1,000 would be considered significant by most people.
Question 3
L1ET-MS05-ME0002-1604
Philip Marit, CFA, is a new analyst with Alpha Advisors. He has been hired to follow the
computer industry, replacing Nancy Engle, who was promoted to the head of research at
the firm. Engle has placed a “buy” recommendation on Dull Computers for the last year,
which has performed well. Because of her success with the stock, Engle instructed Marit
not to change the rating under any circumstances. Marit's best course of action is to:
 a) maintain the “buy” rating as instructed.
b) include Engle's name on the future “buy” recommendations.
c) decline to use his name on recommendations on Dull that were not
reached through appropriate analysis.
Explanation
Marit must have a reasonable basis, supported by appropriate analysis, for his
investment recommendations. In addition, his employment situation should not
compromise his independence and objectivity, although other members of his research
team are compromised. Therefore, his best course of action is to refuse to adhere his
name to an analysis he feels was not reached through objective methods.
Question 4
L1ET-AS05-ME0003-1702
Bill Parker developed a stock-picking model and back-tested it using historical data
from 20X1 to 20X6. The model produced a 40% average annual return over the testing
period. After using the model to manage his personal portfolio in 20X7, it realized an
annual return of 36%. In a marketing brochure, Parker describes the model as “a
reliable system that has yielded average returns in excess of 35% per year over the last
seven years.” To avoid violating Standards I (C): Misrepresentation and III (D):
Performance Presentation, Parker must disclose that the performance record:
a) includes trading his personal portfolio.
b) includes simulated results.
c) is unlikely to be repeated.
Explanation
To avoid misrepresentation and meet the minimum requirements for performance
presentation, Parker must disclose that the average annual return includes only one
period of actual data and the years for which simulated results have been used.
Members or candidates must not state or imply that past returns can be repeated, but
disclosures on that are recommended rather than required. Further, Parker should but
is not required to disclose that this portfolio involves proprietary assets.
Question 5
L1ET-MS05-ME0003-1604
While working at Equity Research Partners, Tanya Kirk developed a sophisticated
spreadsheet model for forecasting earnings and cash flow for domestic companies. She
recently left Research Partners to start her own firm. Kirk may:
a) take her notes with her but not the electronic spreadsheet.
b) take the electronic spreadsheet but not her notes.
c) re-create the electronic spreadsheet from scratch.
Explanation
Upon resigning, Kirk may not remove any of her past work from her former employer
without her supervisor's permission. This prohibition extends to both the spreadsheet
and the notes. Kirk may, however, redo the research and re-create the spreadsheet after
she leaves.
Question 6
L1ET-AS05-ME0004_2212
Steve Wilcox, CFA, is a senior portfolio manager with Capital Alpha Managers (CAM) and
former professional baseball player. He heard through an acquaintance that the Nash
Foundation for the Arts is looking for an asset manager to handle the emerging markets
segment of its $800 million portfolio. Wilcox attends a series of arts gala in search of
Tom Boskin, the current chairman of the foundation. After ingratiating himself to Boskin
at an event, Wilcox begins inviting him to exclusive sporting events, elaborate dinners
with current and former athletes, and recreation on his boat. Wilcox pays for all the
expenses, reminding Boskin about CAM's ability to manage the foundation's emerging
markets investments. In the end, the foundation chose another firm, and Wilcox stopped
inviting Boskin. Did Wilcox violate the Standards of Professional Conduct?
a) Yes.
b) No, because CAM did not win the contract.
c) No, because Boskin did not solicit the invitations from Wilcox.
Explanation
Standard I(B) Independence and Objectivity indicates that members and Candidates
must not offer or accept a benefit in an attempt to sway an opinion. This Standard
prohibits the use of gifting to sway the decisions of those making hiring decisions.
Wilcox's actions imply that he was attempting to influence Boskin by gifting activities
and events. Just because Wilcox's attempts were unsuccessful does not excuse him from
that activity.
Question 7
L1ET-MS05-ME0004-2201
Michelle Wheeler manages the account of a high-net-worth client. The client's
investment policy statement prohibits the use of derivatives. Wheeler's valuation
models indicate that a short-term correction is forthcoming, but longer-term prospects
are still good. She feels that using protective put options (derivatives) is the most cost-
effective technique for tactically adjusting the portfolio. Wheeler's best course of action
is to:
a) sell the assets and incur whatever transaction costs and taxes arise.
b) obtain written permission from the client to deviate from the
guidelines.
c) manage from a total portfolio perspective and execute the options trade.
Explanation
Wheeler should contact her client, explain the strategy, and obtain permission prior to
executing the trades. Deviating from the client's or portfolio's mandate is a violation of
the Standards.
Question 8
L1ET-AS05-ME0005_2212
Hugo Sanchet, CFA, is the chief marketing officer for Orion Investments. Orion manages
several funds, which have all underperformed their benchmarks over the last five-year
horizon. The benchmark indices have all had positive returns in each of the last five
years. Sanchet approved an advertisement that stated, “Orion's clients have prospered
under our careful management. Thanks to the Orion Method, none of our investors has
lost money in any of the last five years.” According to the Standards of Professional
Conduct, Sanchet has:
a) misrepresented his clients' experience over the past five years.
b) misrepresented his firm's skill over the past five years.
c) shrewdly, but accurately, described his firm's performance.
Explanation
While the description of his clients' experience might be accurate from a factual
perspective, claiming that the Orion Method was responsible for client's not losing
money rather than the benchmark is a misrepresentation of the firm's skill. Approving
such a misleading advertisement would be a violation of Standard I(C).
Question 9
L1ET-AS05-ME0006_2212
Elaine Brody is an analyst with Foxtrot Advisors. Foxtrot offers a multilevel service and
fee structure to its clients. Brody posts a summary statement about her downgrade of
Trek Chemicals on the firm's subscription website, which automatically emails clients
about postings. She also emails higher-tiered clients a full detail report and invites them
to participate in a conference call to discuss the rating. Did Brody violate the Standards
of Professional Conduct with respect to fair dealing?
a) No.
b) Yes, because standard subscribers do not have equal access to the detailed
report.
c) Yes, because the Standards require that all clients are treated equally.
Explanation
The Standards allow for differential levels of services for different price points. While
the basic recommendations must be disseminated to all clients as close to
simultaneously as possible, offering additional details and opportunities for interactions
with analysts for higher fees is permitted under the Standard.
Question 10
L1ET-MS05-ME0006_2212
Rene Polin, CFA, is a portfolio manager in the private wealth division of a bank. One of
Polin's clients is quite pleased with the returns his portfolio experienced over the past
three years and invites him to attend the World Series in the client's luxury suite. Polin
and his wife attend the event, enjoying the game and ample refreshments after
obtaining written consent from his supervisor. Did Polin violate the Standards of
Professional Conduct?
a) Yes, because lavish gifts may not be accepted under any circumstances.
b) Yes, because gifts from clients are judged more strictly than gifts from subject
firms.
c) No, because he obtained written consent from his supervisor prior to
acceptance.
Explanation
Members are permitted to accept gifts from clients as long as it does not infringe on
their independence and objectivity. In this case, the reward took place after the action,
was unanticipated, and did not compromise independence or objectivity. Members and
candidates may accept additional compensation, even when it could be seen as
competing with an employer's interests, if the covered person first receives permission
from the employer. Although this reward was not foreseen, could be viewed as
additional compensation for performance, and could cause additional service from the
recipient whether indicated by the client or not, it is acceptable because the employer
provided written consent.
Question 11
L1ET-AS05-ME0007-1604
Todd Elder is a junior analyst with Robust Advisors. One of his duties is to proofread
and fact-check reports issued by the firm's research department prior to release. His
supervisor, Jane Cox, notices Elder's increasingly lavish lifestyle that seems inconsistent
with his income. After checking trading records, Cox discovers that Elder has been
purchasing shares ahead of the release of the research department's recommendations.
Although the firm requires all employees to submit quarterly reports listing personal
trades, Elder has not done so. Which of the following is correct?
a) Both Elder and Cox violated the Standards.
b) Elder violated the Standards but Cox did not.
c) Cox violated the Standards but Elder did not.
Explanation
Elder violated the Standards by front-running the firm's recommendations. Cox violated
the Standard by failing to require that Elder submit his quarterly personal trading
report. Although the firm has a compliance procedure in place to monitor employee
trades, Cox has failed to enforce that procedure with respect to Elder.
Question 12
L1ET-MS05-ME0007_2212
Pablo Vega, CFA, a financial planner, recommends an annuity product from Rock Solid
Insurance, which carries the highest credit rating by several bureaus. The product is
structured to pay the higher of the return on the S&P 500 Index or 3%. In presenting the
product to a client, Vega describes the minimum return as being “guaranteed by one of
the most secure insurance companies in the industry.” Did Vega violate the Standards of
Professional Conduct by making such a claim?
a) No.
b) Yes, because no investment is without some risk.
c) Yes, because guaranteeing returns is categorically prohibited.
Explanation
Standard I(C) Misrepresentation does not prohibit providing information on investment
products that have guarantees built into the product structure or when an institution
has agreed to cover any losses. The analyst should point out that the strength of the
guarantee is limited by the continued financial strength of the insurance company.
Question 13
L1ET-AS05-ME0009-1604
Selma Lopez was an investment banker with Southern Trust. During the course of
employment, she worked very closely with financial officers at local firms. Southern
required all investment bankers to sign a one-year noncompete agreement that
prohibits soliciting existing clients after leaving the firm. Lopez recently left Southern to
join Eastern Bank. Her attorney advises that such noncompete agreements are legally
unenforceable in her jurisdiction. According to the Standards of Professional Conduct,
Lopez may:
a) solicit former clients through publicly available information.
b) only solicit business from former clients who contact her.
c) not solicit any former clients for at least one year.
Explanation
Standard IV (A): Loyalty allows solicitation of former clients as long as contact
information does not come from a former employer's records or violate an applicable
noncompete agreement. Because the noncompete agreement has been deemed
unenforceable, it is no longer applicable.
Question 14
L1ET-MS05-ME0009-1604
Lisa Bloom is a portfolio manager for Lexmore Asset Management. Her neighbor is the
popular founder and CEO of Magnus Industries. Bloom's portfolios own a significant
number of shares in Magnus. At a neighborhood party, the CEO's wife mentioned her
concern about her husband's failing health that will force him to retire very soon, well
before expected. Bloom, concerned about the effect such an announcement will have on
the stock price, sells all her portfolios' holdings in Magnus. Several weeks later, the
dynamic founder's retirement is announced and the stock price drops dramatically.
Blooms actions saved her clients' portfolios from a cumulative loss of several hundred
thousand dollars. Did Bloom violate the Standards of Professional Conduct?
a) No.
b) Yes, because she breached a fiduciary duty to the CEO's wife.
c) Yes, because she traded on material nonpublic information.
Explanation
The information obtained from Magnus' CEO's wife is material because it had the
potential to change the price of the stock, and a reasonable investor would want to
know it before investing. Therefore, Bloom may not trade on the information for herself
or her clients.
Question 15
L1ET-AS05-ME0010-1604
William Tran, CFA, is an analyst with a large brokerage firm and covers Internet retail
companies. His research into Stuff Online, Inc. suggests a steep decline in earnings over
the next 6 to 18 months. He plans on issuing a “sell” recommendation in his next report.
The director of corporate finance calls Tran's supervisor to inform her of a pending deal
with Stuff. Both managers are concerned that a negative research report would kill the
corporate finance deal. The firm's best course of action is to:
 a) give the stock a neutral rating and disclose the corporate finance relationship in
the report.
b) place the stock on a restricted list and report only factual information.
c) give the stock a negative rating without disclosing the corporate finance
relationship.
Explanation
Tran cannot allow the corporate finance deal to influence his independence or
objectivity. Therefore, the best course of action is to place the stock on a restricted list
and report only factual information. This will alert the firm's investment clients that it
has a special relationship with Stuff without taking a position one way or the other with
respect to its valuation.
Question 16
L1ET-AS05-ME0011-1604
Martin Wagner is an associate analyst at Kinder & Wexler. He is part of a research team
preparing a report on Axle Industries. After analyzing all the relevant information,
Wagner feels that the team should issue a sell recommendation. However, the other two
members of his team are less pessimistic about the stock's prospects and complete the
report with a hold recommendation. The firm's equity research committee reviews the
report and supports the hold rating. Wagner's best course of action is to:
a) refuse to put his name on the report until the rating is changed to sell.
b) insist that his dissenting opinion be added to the report before publication.
c) allow his name on the report after noting his dissenting opinion in the
working papers.
Explanation
When part of a group or team, members may dissent from the group's opinion without
removing themselves from the report as long as the process that the team used is fair
and objective. The Standard recognizes that diligent analyses can produce alternative
conclusions. The best practice is to document Wagner's dissent in the working papers
but not necessarily in the report.
Question 17
L1ET-MS05-ME0011-1604
Patrick Evans is a portfolio manager. He recently set up a website with a discussion
forum that allows his clients to ask questions that can be answered by him, his assistant,
or other clients who join the forum. Access to the forum is restricted to registered users,
which are limited to Evans's clients with credentials provided by his assistant. In the
invitation to the forum, Evans includes a description of the forum and cautions that
other users can view public postings. One of his clients posted a question that included a
copy of his recent statement. He was addressing Evans alone, but the post was viewable
by all users. Evans had his assistant remove the post as soon as he spotted it. Did Evans
violate the Standards of Professional Conduct?
a) No.
b) Yes, because he did not provide safeguards against the disclosure of
confidential information.
 c) Yes, because he should have anticipated accidental disclosures and avoided
them.
Explanation
Standard III(E), Preservation of Confidentiality, does require that members take
reasonable steps to ensure that such information is protected. However, Evans did take
reasonable precautions that included limiting access and cautioning against posting
sensitive information. Clients who agree to participate in the forum also have a
responsibility to understand the technology. In this case, the disclosure was executed by
the client, who was cautioned against disclosing sensitive information in the forum.
Question 18
L1ET-MS05-ME0012-1604
Victor Chang is the head of derivatives trading at Kang Bank. He led a firm-wide effort to
upgrade computer systems to monitor derivatives trading and continuously assess the
bank's risk exposure. The firm has extensive procedures in place to monitor and control
trading. Chang's former assistant, Lonnie Sung, was promoted and now works as a
derivatives trader at the bank under the futures trading manager. Sung uses his
familiarity with the compliance systems to execute unauthorized trades. His trading was
discovered after substantial losses for both the bank and several client accounts. Did
Chang violate the Standards of Professional Conduct?
a) Yes.
b) No, because he delegated supervision to the futures manager.
c) No, because he implemented a reasonable compliance system.
Explanation
The Standard requires that supervisors take reasonable steps to prevent and detect
violations. It does not require that all violations be prevented. Sung's exploitation of his
knowledge about the computer safeguards to circumvent them does not translate into a
violation on Chang's part.
Question 19
L1ET-AS05-ME0013-1702
Roger Parks is an analyst with Delta Partners, a large firm offering sell-side research
and investment banking services. In lieu of certain fees, the firm often accepts stock
options on the firms it underwrites. As a partner of the firm, Parks is eligible for an
allocation of those options to his personal account. The general partner called Parks to
remind him that Delta's options in Interworks will expire in a few weeks and suggests
that he write a research report highlighting the stock's upside potential. According to
the Standards of Professional Conduct, Parks may:
a) not write the report due to the conflict of interest.
b) write the report if he discloses the firm's investment banking relationship.
c) write the report if he discloses details of both his and the firm's option
holdings.
Explanation
Parks has a conflict with respect to his firm's interest and his personal interest in
Interworks. The Standard does not prohibit him from writing the report, but he is
required to disclose both conflicts in it.
Question 20
L1ET-MS05-ME0013-1604
Monica Stetz is an investment analyst with Kline & Powers, a small advisory firm
consisting of the president, CFO, and Stetz. Her personal portfolio includes shares in
Petwise, Inc. The president informs her that Kline will initiate coverage on Petwise and
asks her to write a research report on the stock. After disclosing her ownership to the
president, she is instructed to sell her shares immediately to remove the conflict and
then write the report. Stetz sells her shares and subsequently initiates coverage of
Petwise with an unqualified sell recommendation. Did Stetz violate the Standards of
Professional Conduct?
a) No.
b) Yes, by initiating coverage with a sell recommendation.
c) Yes, by creating the appearance of a conflict of interest.
Explanation
While Stetz did not own the shares at the time she wrote the report, selling prior to
issuing a negative report creates the appearance of conflict. The Standard extends to
both real and perceived conflicts because they reflect on the integrity of the charter and
the broader industry. Her best course of action would have been to sell her shares
immediately after dissemination of the report.
Question 21
L1ET-AS05-ME0014_2212
John Randall is a money manager with Insight Asset Managers (IAM). IAM sponsors
luncheons for individual investors where firms present proposals to raise capital. A
small-cap biotech firm, Diamond Diagnostics, presented a promising new technology
that could drive the stock price up dramatically over the next year.
Two of Randall's clients expressed interest in adding the stock to their portfolios. One
client, Margret Burns, is a retiree living on a modest pension supplemented by a mainly
income-producing portfolio. She is identified as risk-averse in her investment policy
statement. The other, Richard Webber, is a wealthy entrepreneur with an aggressively
invested portfolio and is identified as risk tolerant in his investment policy statement.
Randall believes the upside potential for Diamond is genuine. To comply with the Code
and Standards, Randall may make a recommendation to invest in this stock to:
a) either Burns or Webber.
b) Burns but not Webber.
c) Webber but not Burns.
Explanation
Small-cap biotech firms are potentially risky investments. Such investments would only
be suitable for investors with high risk tolerance, which is a function of one's ability and
willingness to take risk. Although both Burns and Webber might be interested in the
investment, only Webber has the ability to assume the risk.
Question 22
L1ET-MS05-ME0014_2212
Pedro Martinez is a portfolio manager with Sol Bank. The bank offers asset management
services and proprietary products to institutional clients. Martinez occasionally attends
meetings to support the sales team with technical expertise. His bonus is, in part,
determined by the success of these sales meetings. In addition, he receives a
commission on each sale of the bank's proprietary products. According to the Standards
of Professional Conduct, Martinez must disclose the additional compensation he
receives from:
a) sales meetings but not proprietary products.
b) proprietary products but not sales meetings.
c) both sales meetings and proprietary products.
Explanation
Guidance to The Standards indicate that disclosures should be made to clients regarding
fee arrangements, subadvisory agreements, or other situations involving nonstandard
fee structures. If there is the potential for apparent or actual conflict of interest, these
fee arrangements must be disclosed. Martinez need not disclose the compensation
arrangement involving the sales meetings. It may be assumed that his involvement is
part of a sales effort for which he might be compensated.
Question 23
L1ET-AS05-ME0015-1604
Which of the following portfolios is least likely to be included in a composite for a GIPS-
compliant performance presentation?
a) A charitable portfolio managed without being charged fees
b) A portfolio dedicated to investing exclusively in real estate
c) A portfolio that was terminated at the end of the last period
Explanation
GIPS require that all fee-paying, discretionary portfolios be included in at least one
composite. A charitable portfolio that pays no fees need not be included in a composite.
Question 24
L1ET-AS05-ME0016_2212
Simon Rush is a broker with FMS Investments. He is preparing a list of stock
recommendations for one of his clients. He gathers several reports from his firm's
research department and carefully reads each one. After selecting the most suitable
stocks, Rush adds his own commentary and sends the recommendations with the
reports to his client. Rush:
a) violated the Standards by using secondary research and by adding his own
commentary.
b) violated the Standards by using secondary research but not by adding his own
commentary.
c) did not violate the Standards by using in-house research or adding his
own commentary.
Explanation
In-house research prepared by colleagues (also called secondary research) is assumed
credible unless the user has some reason to suspect otherwise. Third party research
may also be used if the sources are credible and appropriately cited. Commentary might
add value and is also acceptable, provided fact and opinion are clearly distinguished.
Question 25
L1ET-MS05-ME0016-1604
Wilma Flint is an investment advisor in the United States. She recently met with a
wealthy resident of an Eastern European country who would like to employ her
services. The European country's securities regulations require all investment advisors
to register with the local governing agency before soliciting business or providing
services to its residents. Unaware of the law, Flint issues a service agreement to her new
client and accepts an initial payment to fund the account without a proper registration.
Did Flint violate the Standards of Professional Conduct?
a) Yes, because she should have been aware of the European country's
laws.
b) No, because the Code and Standards do not address registration.
c) No, because she did not knowingly violate any laws.
Explanation
The Standards require members to be aware of and abide by the laws and regulations
governing their work. Ignorance of the law is not an excuse to violate it. If she intends to
conduct business as a professional in Eastern Europe, it is incumbent upon Flint to
educate herself about the local regulations before beginning operations.
Question 26
L1ET-AS05-ME0017-1604
Roger Hamlet works at the trading desk of Tradex, a firm that provides clearing services
to small brokerage firms. Hamlet receives notification from the designated person at
CFA Institute's Professional Conduct Program (PCP) that one of his clients, Jack Russell,
has been accused of churning accounts in order to generate excessive fees. The notice
requests that Hamlet provide Russell's trading records to the investigation. Hamlet's
best course of action is to:
a) refuse to provide records to the PCP.
b) alert other clients to the accusations.
c) cooperate with the PCP investigation.
Explanation
Cooperation with a Professional Conduct Program investigation is required unless
disallowed by applicable law. Cooperating with PCP investigations does not create a
confidentiality violation under the Standards. Members are encouraged to cooperate to
the extent that they may under applicable law.
Question 27
L1ET-MS05-ME0017-2201
Wendy Wells, CFA, is a portfolio manager with Bergan Financial Services. Her
supervisor asked her to provide general descriptions of some basic financial concepts
for the “investor education” section of the firm's website. After searching the Internet,
Wells finds several sources with very similar generic descriptions of diversification,
risk, asset allocation, and other terminology. In completing her assignment,
Wells's best course of action is to:
a) copy the descriptions verbatim and cite “the Internet” as her source.
b) rewrite the text in her own words and cite each website source.
c) rewrite the text in her own words without citing each website
source.
Explanation
By rewriting the text for generic financial concepts in her own words, Wells has created
an original work and need not cite the particular sources.
Question 28
L1ET-AS05-ME0018_2212
Linda Lane manages the domestic equity portfolio for L&L Asset Managers. L&L uses a
six-factor model to rank stocks and select securities. Lane found that the model could be
improved by replacing some variables in the model with other variables. She did not
notify clients of these changes. Did Lane violate the Standards of Professional Conduct?
a) No.
b) Yes, because she made a material change to her investment approach
without notifying clients.
c) Yes, because she failed to follow the investment mandate of her fund.
Explanation
Members or candidates must notify clients when they make material changes to an
investment process. If the changes result in significantly different outcome, then the
changes are material and must be disclosed.
Question 29
L1ET-MS05-ME0018_2212
Shannon Waxman is the director of research for a large investment company. She is an
avid reader of online investment research and commentary. When she posts comments
to other authors' articles, she does so under her anonymous username, “InvestrCFA.”
When she writes articles for her company blog, she posts under her real name,
“Shannon Waxman, CFA.” According to the Standards of Professional Conduct, Waxman
violated the Standards by:
a) posting comments to others' work anonymously.
b) incorporating “CFA” into her anonymous username.
c) including the CFA designation in her own blog articles.
Explanation
Standard VII(B) prohibits users from incorporating the CFA designation in their
anonymous usernames. CFA Institute must be able to identify users by name in order to
verify their valid use of the credential.
Question 30
L1QM-AS05-ME0019_2212
An analyst estimates that a company's earnings could range from ¥2.2 billion to ¥2.8
billion and that any level of earnings between these two earnings estimates are equally
likely. Using a continuous uniform distribution, what is the probability that the next
year's earnings will be greater than or equal to ¥2.68 billion?
a) 7%
b) 20%
c) 37%
Explanation
The earnings range is from ¥2.2 billion to ¥2.8 billion, which is a range of ¥0.6 billion.
We need the portion of this range that is above ¥2.68 billion. The distance between
¥2.68 billion and ¥2.8 billion is ¥0.12 billion and this is 20% of the total (¥0.12 billion /
¥0.60 billion).
Question 31
L1QM-MS05-ME0020_2212
An investment pays the holder $30 quarterly payments over seven years. If the quoted
price is $729.49, the stated annual yield is closest to:
a) 0.65%.
b) 1.00%.
c) 1.64%.
Explanation
The periodic yield is 0.4112% ($3/$729.49). The stated annual yield is 1.64% (4 ×
0.4112%).
Question 32
L1QM-AS05-ME0022_2212
An analyst is using a hypothesis test concerning a population mean (μ). The null and
alternative hypotheses for the test are:

The analyst is using a t-test and included an excerpt of Student's t-distribution in the
table below:
Student's t-Distribution (One-Tailed Probabilities)
Df p = 0.10 p = 0.05 p = 0.025 p = 0.01 p = 0.005
38 1.304 1.686 2.024 2.429 2.712
39 1.303 1.685 2.023 2.426 2.708
40 1.303 1.684 2.021 2.423 2.704
41 1.302 1.683 2.020 2.421 2.701
42 1.302 1.682 2.018 2.418 2.698
The sample size (n) is 39 and the alpha (α) is 0.10. For this hypothesis test, the
acceptance point or range is closest to:
a) t = 1.304.
b) t < −1.304 and t > 1.304.
c) t < −1.686 and t > 1.686.
Explanation
The degrees of freedom are n − 1 = 39 − 1 = 38. The null hypothesis is that the mean is
equal to 0.0058, so in the test, we are concerned whether the mean is significantly
larger or significantly smaller than 0.0058. This means that the 10% alpha is evenly
split between the two tails (5% in each tail). So in Table 1 we use the column labels p =
0.05 and row 38. The resulting t-critical of 1.686 is the number of standard deviations to
the right of the mean (+1.686) or left of mean (−1.686). Observations outside of those
critical t-values would invalidate the null hypothesis, so the acceptance range is −1.686
to 1.686.
Question 33
L1QM-MS05-ME0022-1702
A sample size of 40 is drawn from a normally distributed population. Which of the
following is the appropriate test and degrees of freedom to determine whether the
sample exhibits a specific variance?
a) A t-statistic with 39 degrees of freedom
b) A chi-square (χ2) with 38 degrees of freedom
c) A chi-square (χ2) with 39 degrees of freedom
Explanation
When testing the variance of a single, normally distributed population, the appropriate
test statistic is chi-square (χ2) and the test has n − 1 = 40 − 1 = 39 degrees of freedom.
Question 34
L1QM-MS05-ME0023_2212
An analyst gathered risk premium data and summarized it in the following table:
Interval Absolute Relative Cumulative Relative
Endpoints Frequency Frequency Frequency
4.50% 60 60% 60%
8.25% 22 22% 82%
12.00% 13 13% 95%
15.75% 5 5% 100%
Assuming that risk premia are normally distributed, the analyst would most likely
conclude that this data set is:
a) normally distributed.
b) positively skewed.
c) negatively skewed.
Explanation
A normal distribution has a symmetrical bell shape with a majority of the observations
centered. Positive skew distributions have mean greater than the mode; negative skew
distributions have mean less than the mode. Because 60% of observations fall below the
middle intervals, we could expect this distribution to be positively skewed. The mean
using endpoint values is 6.86% ([(60% × 4.5%) + (22% × 8.25%) + (13% × 12%) + (5%
× 15.75%), which is substantially higher than the 4.5% modal endpoint.
Question 35
L1QM-MS05-ME0024_2212
A reporting service indicates that the following historical performance occurred:
Monthly Data: January 2002 to December 2005
Mean Return (%) Standard Deviation (%) Sharpe Ratio
Small-cap value funds 1.25 2.34 0.410
An analyst wants to determine the probability that small-cap value funds will earn a
monthly return lower than the monthly risk-free rate of 0.29%. He is basing his
estimate of future-period monthly return parameters on the sample mean and standard
deviation provided in the table above and has assumed that the fund returns represent
a normal distribution. Excerpts from the table of the cumulative standard distribution
function for the standard normal probability is included below:
x or z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
−0.30 0.3821 0.3783 0.3745 0.3707 0.3669 0.3632 0.3594 0.3557 0.3520 0.3483
−0.40 0.3446 0.3409 0.3372 0.3336 0.3300 0.3264 0.3228 0.3192 0.3156 0.3121
−0.50 0.3085 0.3050 0.3015 0.2981 0.2946 0.2912 0.2877 0.2843 0.2810 0.2776

0.30 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.40 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.50 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
The probability that the small-cap value fund return is below the risk-free rate of return
is closest to:
a) 34%.
b) 41%.
c) 66%.
Explanation
The first step is to find the Z value for the 0.29%
return:Z=X−μσ=0.29%−1.25%2.34%=−0.41
Using the table provided, the area that corresponds to the Z value of −0.41 is 34.09%.
This means that there is a 34% chance that the monthly return will be below the risk-
free rate of 0.29%.
Question 36
L1QM-AS05-ME0025_2212
Assume that quarterly returns are normally distributed and that the population mean
and standard deviation are unknown. A random sample of 17 quarterly returns had a
mean of 1.5% and a standard deviation of 6.5%. Table 2 below is an excerpt from
Student's t-distribution. Table 2: Student's t-Distribution (One-Tailed Probabilities)
Df p = 0.10 p = 0.05 p = 0.025 p = 0.01 p = 0.005
14 1.345 1.761 2.145 2.624 2.977
15 1.341 1.753 2.131 2.602 2.947
16 1.337 1.746 2.120 2.583 2.921
 Df p = 0.10 p = 0.05 p = 0.025 p = 0.01 p = 0.005
17 1.333 1.740 2.110 2.567 2.898
18 1.330 1.734 2.101 2.552 2.878
The 95% confidence interval for the population mean of quarterly returns is closest to
a) −1.25% to 4.25%.
b) −1.84% to 4.84%.
c) −1.94% to 4.94%.
Explanation
Because the sample size is small, the reliability factor should be based on Student's t-
distribution. With a sample size of 17, the degrees of freedom are 16 (n − 1 = 17 − 1).
Given the desire for a 95% confidence interval, the amount of area in each tail is 0.025
(α/2 = 0.05/2). Therefore, using the table, the reliability factor (i.e., critical value) is
determined to be 2.120. The 95% confidence interval is calculated as follows:

Question 37
L1QM-MS05-ME0025-1604
A junior associate is assigned the task of analyzing a bank's customer account mix. He is
presented with the following data:
Account Column A Ratio of Account Column B Ratio of Account Type to
Type Type to Bank Customers Total Open Accounts at the Bank
Checking 0.70 0.45
Saving 0.35 0.23
Loans 0.50 0.32
Based solely on the information provided, which of the following
statements best describes the data presented in the table?
a) Column A is mutually exclusive and collectively exhaustive.
b) Column B is mutually exclusive and collectively exhaustive.
c) Column A is mutually exclusive but not collectively exhaustive.
Explanation
In order for a data set to be mutually exclusive and collectively exhaustive, the
probabilities of each event must sum to 1.0. The sum of the probabilities in Column A is
1.55, which exceeds 1.0. Therefore, we must conclude that each customer can have
more than one type of account and accounts are not mutually exclusive. Column B does
sum to 1.0 and, since it looks at all the accounts at the bank, we would expect them to be
mutually exclusive and collectively exhaustive.
Question 38
L1QM-AS05-ME0026-2201
A trader has two limit orders in place for each of two stocks, Iridium (IRDM) and
Verizon (VZ). She estimates that the probability of the IRDM trade executing before the
end of the day is 0.50. However, there is only a 15% chance that the VZ trade will
execute over the same period. If the probability of both trades executing before the
close is 0.09, what is the probability that either one or the other will execute?
a) 65%
b) 56%
c) 33%
Explanation
The union probability is found using the addition rule of probability:
P(A or B) = P(A) + P(B) − P(AB) = 0.50 + 0.15 − 0.09 = 0.56 = 56%
Question 39
L1QM-MS05-ME0026-2201
A company is known for engaging in numerous restructurings, which involve taking
“one-time” charges. An analyst determines that in the past 10 years, the company has
restructured four times and not restructured six times. Assuming this pattern will
continue in the future, the analyst wants to determine the probability that the company
will restructure exactly twice in the next 10 years. Based on the data provided, the
analyst should conclude that this probability is closest to:
a) 1%.
b) 12%.
c) 20%.
Explanation
Based on the past, the probability of a restructuring in any given year is 40% (4 out of
10). The following calculation shows the determination of the probability of exactly two
restructurings in the next 10 years:

Question 40
L1QM-MS05-ME0027-2201
Assume the corporate bond spread over Treasuries is normally distributed with a
population mean of 2.0% and a population standard deviation of 8.0%. Over the past six
years, the corporate bond spread over Treasuries has averaged 5.0%. An analyst
considers this to be highly unusual and wants to determine whether the recent result is
likely 90% of the time, given the population's statistics. The confidence interval around
the population mean that the analyst will calculate is closest to:
a) −4.4% to 8.4%.
 b) −3.4% to 7.4%.
c) −0.2% to 4.2%.
Explanation
A 90% confidence level has a critical Z-value of 1.65, with the Z-value being used
because the population standard deviation is known. Given the population data and the
six-year period, the confidence interval is calculated as follows:

Question 41
L1QM-AS05-ME0029-2201
A merger arbitrage hedge fund manager is considering using a scoring model to test the
likelihood that a merger deal will close within six months. Back-testing the model
produced the following results:

• P(Closed on time) = 0.70

• P(Passed test) = 0.76
• P(Passed test | Closed on time) = 0.82

The manager uses the model to score a new deal. If the deal fails the scoring test, what is
the updated probability that it will not close within six months?
a) P(no close | failed) = 0.245
b) P(no close | failed) = 0.475
c) P(no close | failed) = 0.705
Explanation
Let:
P(fail) = 1 – P(passed) = 1 – 0.76 = 0.24
P(no close) = 1 – P(close) = 1 – 0.70 = 0.30
Using Bayes theorem:

Then no close given failure is:

Question 42
L1QM-MS05-ME0029_2212
Ty Kepler is a pension fund manager. He utilizes the services of several portfolio
managers to handle the equity, fixed-income, and real estate segments of the fund.
However, Kepler makes all the allocation and rebalancing decisions. As the fund
manager, he must periodically evaluate the portfolio managers to determine when a
change is to be made. He gathered the following performance data on his current roster:
Manager Time-Weighted Money-Weighted Benchmark
Red 5.6% 7.2% 7.2%
White 8.2% 7.4% 8.0%
Blue 6.5% 4.5% 5.6%
Based only on the information provided, which manager should Kepler consider
replacing?
a) Red
b) White
c) Blue
Explanation
The most appropriate return metric for evaluating manager performance is the time-
weighted return. Red is the only manager failing to exceed the benchmark based on
time-weighted return and should be replaced.
Question 43
L1QM-AS05-ME0031-2201
Balance sheet and income statement data denominated in Indian rupees would best be
described as:
a) ratio-scaled.
b) ordinal-scaled.
c) nominal-scaled.
Explanation
Figures used to denominate currency are ratio-scaled data because they can be
meaningfully ranked and used to perform calculations. Currency can be meaningfully
added, subtracted, and used to compute ratios.
Question 44
L1QM-MS05-ME0032-2212
Standard error of the estimate, se, would least likely be described as:
a) the square root of sum of the squared errors (SSE).
b) a goodness-of-fit measure for the estimated regression line.
c) an absolute measure of the distance of the observed dependent variable from
the regression line.
Explanation
Standard error of the estimate is the square root of the mean squared error rather than
the sum of squared errors:
Standard error of the estimate measures the distance of the observed dependent
variable from the regression line and is therefore a “goodness-of-fit” measure for the
regression line.
Question 45
L1EC-AS05-ME0033-2201
Monetarists attribute the primary cause of the business cycle to:
a) exogenous shocks and government intervention.
b) disequilibrium in the labor markets.
c) shifts in aggregate supply.
Explanation
The monetarist school focuses on the growth of the money supply and believes in a
limited role for government intervention.
Question 46
L1QM-MS05-ME0033-2201
An investor uses a stock screener to identify stocks on which to perform a more in-
depth analysis. The first criterion limited the result to dividend-paying stocks, which
eliminated 35% of the stocks in the investment universe. The second criterion looked
for stocks that trade at less than three times book value, leaving only 0.50% of the total
universe that passed both criteria. The probability that a stock from this investment
universe trades at less than three times book value, given that it pays a dividend
is closest to:
a) 0.77%.
b) 15.0%.
c) 43.0%.
Explanation
The conditional probability is

Question 47
L1EC-AS05-ME0034-1702
If a firm is able to increase output while reducing its costs of inputs, it is experiencing:
a) constant returns to scale.
b) diseconomies of scale.
c) economies of scale.
Explanation
Output increases at a higher rate or proportion to inputs when a firm experiences
increasing returns to scale.
Question 48
L1EC-MS05-ME0034-1702
The spot rate for a currency exchange rate is 1.5865 and the six-month forward rate is
1.6500. The six-month forward points are closest to:
a) 0.0635
b) −0.0635
c) 635
Explanation
The number of forward points equal the forward rate minus the spot rate multiplied by
10,000; or 1.6500 − 1.5865 = 0.0635; 0.0635 × 10,000 = 635.
Question 49
L1EC-AS05-ME0035-1604
According to the Fisher effect:
a) a change in the expected inflation rate causes the real rate to rise.
b) the nominal rate of interest plus the expected inflation rate is equal to the real
rate of interest.
c) changes in inflation expectations cause the nominal rate of interest to
change.
Explanation
The Fisher effect (or equation) states that the real rate of interest is stable and that the
nominal rate of interest will change when inflation expectations change.
Question 50
L1EC-AS05-ME0036-1604
Over the last year the USD has depreciated 15% relative to the GBP. How much has the
GBP appreciated relative to the USD?
a) Exactly 15%
b) Less than 15%
c) Greater than 15%
Explanation
The appreciation of the GBP is the inverse of the appreciation of the USD: [1 / (1 −
0.15)] − 1 = 0.17 or 17%.
Question 51
L1EC-MS05-ME0036_2212
In the long run, a firm under perfect competition will:
a) have economic profit that exceeds accounting profit.
b) reach a point where accounting profit is equal to economic profit.
c) have zero economic profit.
Explanation
In the long run, competition will reduce prices and result in the firm's having a normal
profit.
Question 52
L1EC-AS05-ME0037-2201
Unemployed workers at the business cycle peak will most likely be:
a) Discouraged workers.
b) Long-term unemployed.
c) Frictionally unemployed.
Explanation
Frictional unemployment is a short-term, often voluntary condition such as
unemployment resulting when a worker has left one job and is about to start another, is
a new entrant to the job market, or is between jobs (often due to voluntary separation
such as looking for a “better fit”). Discouraged workers are brought back into the labor
force as the economy expands, and the long-term unemployed have usually found work.
Question 53
L1EC-MS05-ME0037-1604
When a central bank sells government bonds to commercial banks, it is likely:
a) increasing broad money supply.
b) reducing the reserves of commercial banks.
c) entering into a repurchase agreement.
Explanation
Bond purchases by commercial banks during a central bank's open market operations
reduce their ability to make loans due to lower bank reserves.
Question 54
L1EC-MS05-ME0038_2212
In a Keynesian model, a cut in government spending and commensurate reduction in tax
burden would shift the:
a) IS and LM curves.
b) IS and aggregate demand curves.
c) LM and aggregate demand curves.
Explanation
The IS curve shows income and real interest rates where planned expenditure equals
income. Lower government spending and lower taxes will increase private consumption
and savings. The responsive shift in aggregate income Y will depend on the slope of the
line equating I + G = S0 + T to Y at various levels of the real interest rate.
Question 55
L1EC-AS05-ME0039_2212
The inventory/sales ratio is most likely to be falling:
a) at the bottom of an early expansion.
 b) during the middle of an expansion.
c) at the end of an economic expansion.
Explanation
A declining inventory-to-sales ratio, a lagging indicator, is consistent with an early
recovery. Sales pick up during the expansion and the firm is not yet recognizing this and
producing more inventory.
Question 56
L1EC-MS05-ME0039-1702
Given the following demand function:

where the quantity demanded is of good x, Py is the price of good y, and I is the
consumer's income, then the relationship between good y and good x is such that they
are:
a) complements.
b) substitutes.
c) independent.
Explanation
The term in the equation “−0.5PY” indicates an inverse cross-price relationship between
goods x and y; that is, the quantity demanded of x decreases as the price of y increases.
Therefore, goods x and y are complements.
Question 57
L1EC-AS05-ME0040-1702
Negative cross-price elasticity is indicative of:
a) complements.
b) substitutes.
c) a decrease in income.
Explanation
If the cross elasticity is negative, this signifies that an increase in the price of one good
results in a decrease in the quantity consumed of the other good. As own-price
increases, the consumption of the good will decrease. Therefore, the amount consumed
of both goods declines with a price increase of one of the goods; they are
complementary goods.
Question 58
L1EC-MS05-ME0040-1604
A country enjoys a comparative advantage in producing a good if:
a) it can produce more of a good at a lower cost than anyone else.
b) its labor costs are lower than those of its competitors.
c) its opportunity costs are lower than those of its competitors.
Explanation
Comparative advantage is a function of reduced opportunity cost. If a country gives up
less of something than its trading partners to make a good, then it should specialize in
that good.
Question 59
L1EC-MS05-ME0041_2212
What is the most likely reason for an increase in money demand?
a) Real GDP is falling.
b) Consumers are making fewer transactions.
c) Interest rates on bonds are low.
Explanation
Demand for speculative balances will rise when bond yields are low.
Question 60
L1EC-AS05-ME0042-1604
Purchasing bonds in open market operations is most likely an example of which type of
monetary policy?
a) Expansionary
b) Contractionary
c) Target independent
Explanation
When central banks purchase bonds in the open market from dealers or designated
market makers, reserves rise, money is created in the financial system, and a bank's
capacity to make loans increases.
Question 61
L1EC-MS05-ME0042-1604
An economist is evaluating the competitive market structure of a particular industry. He
computes the Herfindahl-Hirschman Index (HHI) to be 0.0125. That is equivalent to
how many firms with equal market shares?
a) 5 firms
b) 80 firms
c) 120 firms
Explanation
The reciprocal of the HHI provides an indication of how many firms would participate in
the industry if the market were evenly divided among them. 80 = 1/0.0125
Question 62
L1EC-AS05-ME0043-1604
Which of the following market structures is least likely to observe nonprice competition
among its sellers?
a) Oligopoly
b) Monopolistically competitive
 c) Perfectly competitive
Explanation
Perfectly competitive markets typically trade in homogenous products and companies
do not compete based on differentiation. Non-price competition, including advertising,
dominates market structures that are characterized by differentiated products.
Question 63
L1EC-MS05-ME0043-1604
A central bank in a developed economy is least likely to use which monetary policy tool?
a) Open market operations
b) The central bank's policy rate
c) Reserve requirements
Explanation
Changing reserve requirements is a frequently used tool in developing economies; it is
rarely used in developed economies by central banks due to its wide affects throughout
an economy. It is also expensive for banks to modify their procedures, collect
outstanding obligations, or borrow to meet higher reserve requirements.
Question 64
L1FR-MS05-ME0046_2212
Theo, Inc. had an average number of days of inventory on hand of 12 in the most recent
year. The company wants to increase the amount of inventory on hand to avoid missing
out on potential sales. Theo has determined that its days of inventory on hand for the
next fiscal year should match the industry average of 18 days. The company's cost of
sales for the most recent fiscal year was a total of $2,324 million, and Theo expects cost
of sales to increase 10% in the next fiscal year. To achieve the company's goal of
increasing its number of days of inventory on hand, the change in the average inventory
balance that must occur is closest to:
a) $40 million.
b) $45 million.
c) $50 million.
Explanation
First find cost of sales for the next period:

Next, determine the daily cost of sales multiplied by days sales on hand for each period:

Question 65
L1FR-AS05-ME0047_2212
An analyst has gathered the following three years of data (in £ millions) for a company:
 20X3 20X2 20X1
Select Data from Income Statements
Revenue 800 770 700
Earnings before taxes and interest (EBIT) 80 75 67
Interest expense (paid) 11 10 10
Taxes 19 20 17
Profit for year 50 45 40
Select Data from Balance Sheets
Total current assets 300 250 200
Fixed assets, net 600 570 560
Short-term debt 100 100 100
Total current liabilities (including short-term debt) 330 315 305
Long-term debt 120 105 100
Equity 450 400 355
Total liabilities and equity 900 820 760
In addition to the data above, the analyst has estimated that the company's total annual
cash expenditures for 20X3, 20X2, and 20X1 were £550, £520, and £480 million,
respectively.
Comparing 20X3 with 20X2, the most reasonable conclusion an analyst might make
about the company's profitability is that it:
a) improved, as indicated by the gross profit margin rising from 9.7% in 20X2 to
10% in 20X3.
b) deteriorated, as indicated by the return on equity falling from 11.92% in
20X2 to 11.76% in 20X3.
c) deteriorated, as indicated by the return on equity falling from 12.68% in 20X2
to 12.50% in 20X3.
Explanation
The return on equity (net income / average equity) fell from 11.92 to 11.76%, which is
an indication of deteriorating profitability. The calculations are as follows:

In doing these calculations, it is critical to use average equity. Finally, the gross profit
margin cannot be found, as we are not given gross profit or COGS.
Question 66
L1FR-MS05-ME0047-1702
A financial analyst at Kingston Semiconductor, an Irish firm, is computing the
depreciation expense of a piece of manufacturing equipment for the fiscal year ended
December 31, 2008. The equipment was acquired on January 1, 2008. The analyst
discovers the following information (currency in euros):
Cost of the equipment €4,800,000
Estimated residual value €1,000,000
 Expected useful life 7 years
Total productive capacity 4,000,000 units
Production in FY 2008 275,000 units
Expected production for next six years 3,725,000 units total
If Kingston uses the double-declining depreciation method, the amount of depreciation
expense on Kingston's income statement is closest to:
a) €1,085,714.
b) €1,371,429.
c) €1,657,143.
Explanation
Depreciation expense under the double-declining balance method is (2/7) × $4,800,000,
or 1,371,429 euros.
Question 67
L1FR-AS05-ME0048-1604
Which of the following is least likely to be a consideration that a company would make
when managing its liquidity?
a) Maintaining enough cash and other liquid assets to ensure that it can
meet capital expenditures
b) Avoiding excessive amounts of cash because the return on cash is less than the
company's cost of capital to finance its assets
c) Accumulating cash that will be used for acquisitions
Explanation
Considerations that a company takes in managing its liquidity include maintaining
enough cash and other liquid assets to ensure it can meet near-term operating
expenditures and unexpected needs; avoiding excessive amounts of cash; and
accumulating cash that will be used for acquisitions.
Question 68
L1FR-MS05-ME0048_2212
A conservative accounting choice is most likely to:
a) be neutral.
b) increase reported earnings.
c) decrease reported earnings.
Explanation
Conservative accounting choices decrease a company's reported performance by
decreasing revenues or increasing expenses. Consequently, the financial performance
for the current period would most likely exhibit a downward bias.
Question 69
L1FR-AS05-ME0049_2212
Martin Stores adheres to IFRS. In 2011 the net realizable value of its inventory was
below cost and the value of inventory was written down by €0.3 million. In 2012, the
company reversed the entire amount of the write-down. Martin Stores,' CFO calculated
the financial ratios of the company with and without the write-down. If the write-down
had not occurred, Martin Stores reported 2011:
a) gross profit margin would have been higher.
b) inventory turnover ratio would have been higher.
c) number of days of inventory on hand would have been lower.
Explanation
COGS = beginning inventory + purchases − ending inventory. Write-downs therefore
raise COGS, which has the effect of lowering gross profits, taxable income and gross
profit margin. Without the write-down, gross profit margin would have been higher.
The second choice is incorrect because the inventory turnover ratio would be lower due
to lower cost of sales in the numerator and higher average inventory in the
denominator.
The third choice is the inverse of the second. Inventory turnover ratio would be lower
without the write-down, so the number of days of inventory on hand would be higher.
Question 70
L1FR-MS05-ME0052_2212
Which of the following would least likely be considered a non-financial risk?
a) Being sued by a client
b) Extreme and adverse events occurring more often than predicted
c) A substantial and adverse movement in price when trying to sell an
investment
Explanation
This is liquidity risk, which would be considered a financial risk.
Question 71
L1FR-AS05-ME0053-1604
A company's fixed charge coverage can help an analyst determine the company's ability
to cover its:
a) daily cash expenditures.
b) required return on equity.
c) lease and interest payments.
Explanation
The fixed charge coverage measures how many times a company's earnings (EBIT +
lease payments) can cover its interest and lease payments and it is calculated as follows:

Question 72
L1FR-MS05-ME0053-1702
Runway, a fashion clothing company, reported annual revenue of $500 million, total
expenses of $100 million, and net income of $20 million. If accounts receivable
increased by $25 million, how much cash did the company receive from its customers?
 a) $500 million
b) $475 million
c) Nothing; the company is owed $5 million
Explanation
If accounts receivable increased by $25 million, then the company received $500 million
− $25 million = $475 million cash from customers. An increase in accounts receivable
signals that the company had a decrease in cash that is equal to the increase in
receivables.
Question 73
L1FR-AS05-ME0054-1604
What type of audit opinion is preferred when analyzing financial statements?
a) Qualified
b) Superior
c) Unqualified
Explanation
An unqualified opinion is a “clean” opinion and indicates that the financial statements
present the company's performance and financial position fairly in accordance with a
specified set of accounting standards.
Question 74
L1FR-MS05-ME0054-1604
SmashToys purchases and distributes SquishBalls. At the start of Year 1, SmashToys had
no inventory on hand. It purchased 70,000 units at $3 and sold 55,000 of them for
$5.75. In Year 2, SmashToys purchased 100,000 additional units and received a bulk
discount rate of $2.85. In Year 2, the company sold 80,000 units at the same price of
$5.75. The company uses the weighted average cost method to value its inventory. The
gross profit margin for Year 2 is closest to:
a) 47.8%.
b) 50.1%.
c) 50.4%.
Explanation
Inventory and sales data for the two years are:
Purchased Sold
Units Price Units Price
Year 1 70,000 $3.00 55,000 $5.75
Year 2 100,000 $2.85 80,000 $5.75
After year 1, there were 15,000 (70,000 – 55,000) units remaining in inventory at $3.00
per unit. Average inventory price for year 2 is $2.87 per unit [(15,000 × $3.00 + 100,000
× $2.85)/115,000].
Question 75
L1FR-AS05-ME0056-0220
Which of the following is most likely to be a key criticism of “robo-advisory” services?
a) Loss of jobs for human practitioners
b) Potential failure during normal market conditions
c) Lack of transparency and rationale around recommendations
Explanation
The formulation and underlying justification of robo-advice recommendations is less
likely to be communicated effectively to clients as opposed to those developed and
presented by a human advisor.
Question 76
L1FR-AS05-ME0057-1604
PLC Inc. paid $24,000 of cash to a real estate company upon signing a lease on
December 31, 2012. The payment represents an $8,000 security deposit and $8,000 of
rent for each of January 2013 and February 2013. Assuming that both January and
February rent are correctly reflected as prepaid, the most likely effect on PLC's
accounting equation in December 2012 is:
a) No net change in assets.
b) A decrease in assets of $16,000.
c) A decrease in assets of $24,000.
Explanation
Cash (an asset) decreases by $24,000 in 2012. Deposits (an asset) increase by $8,000.
Prepaid rent (an asset) increases by $16,000. There is no net change in assets.
Question 77
L1FR-AS05-ME0058-1604
Magic Prizes purchases and distributes magic wands. At the start of 2010, Magic Prizes
had no inventory on hand. It purchased 70,000 units at $3 and sold 55,000 of them for
$5.75. In the following year, Magic Prizes purchased 100,000 additional units and
received a bulk discount rate of $2.85. In 2011 the company sold 80,000 units at the
same price of $5.75. The company uses the FIFO method to value its inventory. In 2011,
the company's ending inventory balance is closest to:
a) $99,750.
b) $100,435.
c) $102,000.
Explanation
Magic Prizes uses FIFO to value inventory, therefore the first units in (the oldest units)
are the first units sold. In this scenario, prices are declining. Ending inventory is made
up of the most recent purchases at the lower unit cost of $2.85. At the end of 2011,
35,000 units remain in inventory at a unit cost of $2.85 ($99,750).
The second choice is ending inventory under the weighted average cost method, and the
third choice is ending inventory under LIFO.
TIP: You did not need to do the math on this problem if you remember that in an
environment of declining prices, FIFO will have the lowest ending inventory.
Question 78
L1FR-MS05-ME0058-1604
Use the following selected financial information for Polymath Steel to answer the
question that follows the data:
20X2 ($000s) 20X1 ($000s)
Pretax income (13,366) 41,440
Income tax expense 15,668 21,516
Net income (29,034) 19,924
Deferred tax items
Net operating loss carryforward 14,807 6,690
Other tax assets 9,025 11,894
Subtotal 23,832 18,584
Valuation allowance (22,131) (3,688)
Net deferred tax assets 1,701 14,896
Total deferred tax liabilities (4,537) (1,337)
Net deferred tax asset (liability) (2,836) 13,559
If Polymath offsets all of its deferred tax assets each year with a valuation allowance,
what would be the adjusted income tax expense in 20X2?
a) $5,848
b) $17,369
c) $19,122
Explanation
Deferred tax assets would decrease by an additional $1,701, which would raise the
income tax expense to $1,701 + $15,668 = $17,369.
Question 79
L1FR-AS05-ME0059-1604
A decomposition of a company's ROE is as follows:
FY13 FY12
ROE 14.5% 14.5%
Tax burden 0.71 0.71
Interest burden 0.95 0.90
EBIT margin 8.9% 9.0%
Asset turnover 2.10 2.10
Leverage 1.15 1.20
Based only on this ROE decomposition, an analyst might conclude that in FY13 the:
a) net profit margin increased, while leverage declined.
b) net profit margin declined, while leverage increased.
 c) increase in interest costs was offset by the increase in leverage.
Explanation
Interest costs fell, not rose, as reflected by the increased interest burden factor. This
benefit was somewhat offset by a lower EBIT margin. In total, the net profit margin (net
income/revenue) rose in FY13. This outcome can be found by multiplying the EBIT
margin by the tax and interest burdens. The calculations are

Leverage declined from 1.20 to 1.15. ROE was unchanged in FY13 because the decline in
leverage was offset by the rise in net profit margin.
Question 80
L1FR-MS05-ME0059-1604
Banff Brothers just acquired a new smelter for their business. The purchase price was
$20,000, delivery charges were $4,500, and installation cost $2,500. In addition, Banff
spent $4,000 on training employees how to use the smelter. How much should be
recognized on Banff's balance sheet?
a) $24,500
b) $27,000
c) $31,000
Explanation
At acquisition, the purchase price is recognized along with any costs needed to get the
asset ready for use. Training costs, however, are expensed in the period incurred.
Question 81
L1FR-MS05-ME0060-1702
At a recent trade show, three purchasing managers placed an order for the new Turbo
8000. At the end of the machine's first year in use, each of their accounting managers
discussed with them the machine's estimated useful life. Which of the following
accounting treatments is the least conservative approach for calculating the assets'
depreciation expense for the first year in use?
a) Company A used the straight-line method with a useful life of eight
years.
b) Company B used the straight-line method with a useful life of five years.
c) Company C used the double-declining-balance method with a useful life of
eight years.
Explanation
The least conservative choice is the one that would deduct the least amount of
depreciation expense and report the higher net income. Of the three choices, the first
choice—straight-line with a longer useful life—would result in the smallest charge for
depreciation expense in the first year.
Question 82
L1FR-AS05-ME0062-1604
Juicy Jumpers reported interest expense of $9 million and taxes of $5 million. If the
interest payable account increased by $2 million and taxes payable decreased by $3
million, how much cash did the company pay for interest and taxes?
a) $7 million in interest and $8 million in taxes
b) $9 million in interest and $5 million in taxes
c) $11 million in interest and $3 million in taxes
Explanation
Interest expense of $9 million less the interest payable of $2 million equals interest paid
of $7 million. Tax expense of $5 million less the decrease in taxes payable of $3 million
equals taxes paid of $8 million.
Question 83
L1FR-AS05-ME0064_2212
An analyst is evaluating the balance sheet of a U.S. company that uses last in, first out
(LIFO) accounting for inventory. The analyst collects the following data:
Dec 31, X5 Dec 31, X6
Inventory reported on balance sheet $1,000,000 $1,200,000
LIFO reserve $100,000 $140,000
Average tax rate 30% 30%
After adjusting the amounts to convert to the first in, first out (FIFO) method, inventory
at December 31, 20X6, would be closest to:
a) $1,200,000.
b) $1,240,000.
c) $1,340,000.
Explanation
To convert LIFO inventory to FIFO inventory, the entire LIFO reserve must be added
back to inventory: $1,200,000 + $140,000 = $1,340,000.
Question 84
L1FR-MS05-ME0064_2212
Conversion of a convertible bond to equity would be reported as:
a) an investing cash inflow and outflow.
b) financing cash outflow and inflow.
c) a supplemental disclosure to the cash flow statement.
Explanation
Noncash transactions are reported as supplementary information rather than in the
investing or financing sections of the cash flow statement.
Question 85
L1FR-AS05-ME0065-1604
Preferred shares with mandatory redemption at a fixed amount at a future date are
classified as a(n):
a) asset.
b) liability.
c) equity.
Explanation
Preferred shares with mandatory redemption at a fixed amount at a future date are
classified as a liability whereas perpetual, nonredeemable preferred shares are
classified as equity.
Question 86
L1FR-MS05-ME0065-1604
Companies A, B, and C are new entrants in the same industry competing against one
another. Details of their purchases and inventory valuation methods are listed below.
Units Purchased Quarterly Inventory Valuation Method Used
Company A 30,000 FIFO
Company B 10,000 Weighted average cost method
Company C 16,000 LIFO
If industry supply prices steadily increased throughout the year, which company
will most likely have the highest inventory turnover ratio?
a) Company A
b) Company B
c) Company C
Explanation
Inventory turnover ratio=Cost of salesAverage inventory
The company with the highest inventory turnover ratio will be the company with the
highest cost of sales and lowest ending inventory; that is Company C. During a period of
rising prices, under LIFO, the earliest (oldest) purchases or units manufactured remain
in inventory and are assigned a lower cost. The newest goods purchased or
manufactured are considered sold and assigned a higher cost.
Question 87
L1FR-MS05-ME0066-1702
An analyst has collected the following information regarding a company in advance of
its year-end earnings announcement (in millions):
Estimated net income $400
Beginning retained earnings $2,400
Estimated distribution to owners $200
The analyst's estimate of ending retained earnings (in millions) should be closest to:
a) $2,600.
 b) $3,000.
c) $3,400.
Explanation
The calculation is as follows:
Beginning retained earnings $2,400
+ Net Income 400
− Distributions to owners (200)
= Ending retained earnings $2,600
Question 88
L1FR-MS05-ME0068-0220
Distributed ledger technologies might be able to reduce costs by:
a) Generating automatic trading systems and programs.
b) Allowing transactions without the need for a third party.
c) Performing tasks that would otherwise involve human intervention
and analysis.
Explanation
This type of fintech area falls under artificial intelligence/analytical tools. Distributed
ledger technologies refers to the tracking of asset ownership without the need for
external exchanges or registries.
Question 89
L1FR-AS05-ME0068-1604
A company has one customer (X-INP Corp) that accounted for over 30% of the
company's accounts receivable balance at the start of 20X3. No sales were made to X-
INP Corp in 20X3 and no payments were received from X-INP. Furthermore, during
20X3, X-INP filed for bankruptcy and defaulted on all amounts it owed to creditors. As a
result, the company determined that it would never receive payment on the amount it
was due and wrote off X-INP's receivable balance as a bad debt just before the fiscal
20X3 year end. If the write-off had not occurred, days sales outstanding for 20X3
would most likely be:
a) lower.
b) higher.
c) the same.
Explanation
The write-off will reduce the ending receivables balance substantially from what it
would have been otherwise. As a result, the average receivables for 20X3 that the
analyst calculates will be lower than they would have been without the write off. Since
no sales were made to X-INP Corp in 20X3, the 20X3 revenues are unaffected by
whether the write-off occurred or not.
With the write-off causing no change in revenues and lower average receivables, the
analyst's calculated receivables turnover (revenue / average receivables) will have been
lower. The higher receivables turnover will then cause the calculated days of sales
outstanding (365 / receivables turnover) to be higher.
Question 90
L1FR-AS05-ME0067_2212
A company wishing to increase earnings in future periods would least likely:
a) impair property, plant, and equipment.
b) raise estimates of uncollectible accounts receivables.
c) capitalize rather than expense a purchase.
Explanation
Capitalizing rather than expensing a purchase would increase earnings in the current
period and decrease it in future periods. If a company wants to increase reported
earnings in future periods, the company's managers may write-down an asset and
increase the expense in the current year, reducing depreciation in future periods, or
increase the allowance for uncollected accounts and uncollected accounts expense
reported in the period.