Financial Statement Analysis — CFA Level I practice questions

Under IFRS 16, a lessee's right-of-use asset is amortized over the:

1. Useful life of the underlying asset
2. Lease term including all renewal options
3. Shorter of lease term or asset useful life
4. Longer of lease term or asset useful life

Answer: C — Shorter of lease term or asset useful life

A) Ignores lease-term limit. B) Includes uncommitted renewal options. C) Correct — IFRS 16 uses the shorter of the two periods. D) Reverses the correct rule.

A firm's quick ratio is 1.2 and current ratio is 2.0. The gap is MOST likely explained by:

1. Cash holdings excluded from the quick ratio
2. Short-term debt excluded from the current ratio
3. Inventory and prepaid expenses in current assets
4. Marketable securities counted only in current ratio

Answer: C — Inventory and prepaid expenses in current assets

A) Cash is included in quick assets, not excluded. B) All short-term debt sits in current liabilities. C) Correct — quick ratio strips inventory and prepaids. D) Marketable securities appear in both ratios.

Under U.S. GAAP, inventory is typically carried on the balance sheet at the:

1. Fair market value on the reporting date, with unrealized gains recognized in current-period income
2. Expected final sale price to customers, net of anticipated selling and distribution period costs
3. Historical cost only, with no impairment write-downs permitted in later interim reporting periods
4. Lower of cost or market, with IFRS instead using lower of cost or net realizable value each period

Answer: D — Lower of cost or market, with IFRS instead using lower of cost or net realizable value each period

A) GAAP does not mark inventory to market with gains recognized. B) Selling price alone is not the measurement basis under either regime. C) Impairment write-downs to LCM are required, not optional. D) Correct — GAAP LCM versus IFRS LCNRV are the two standards.

Goodwill is recognized when:

1. An entity's market value exceeds its book value
2. A firm acquires another and pays above fair value
3. Stock prices rise above the reported book value
4. Internally developed brands appreciate materially

Answer: B — A firm acquires another and pays above fair value

A) Market-vs-book differences alone do not generate booked goodwill. B) Correct — goodwill is the residual purchase price over fair value of identifiable net assets. C) Share-price movements do not book goodwill. D) Internally generated goodwill is not recognized under IFRS or GAAP.

Commercial mortgage-backed securities (CMBS) differ from residential MBS in that CMBS typically exhibit which of the following contractual and structural features?

1. Carry substantially higher prepayment risk than residential MBS across essentially all interest-rate environments and across all economic cycle conditions
2. Restrict prepayment through lockouts, defeasance requirements, prepayment penalties, and yield-maintenance provisions in the underlying loan documentation
3. Are unconditionally guaranteed by the U.S. federal government agency that supervises the commercial mortgage market for institutional investors and issuers

Answer: B — Restrict prepayment through lockouts, defeasance requirements, prepayment penalties, and yield-maintenance provisions in the underlying loan documentation

A) Residential MBS carries more prepayment risk than CMBS. B) Correct — CMBS contractually reduces prepayment optionality. C) CMBS is not federally guaranteed.

The preferred-habitat theory of the term structure holds which of the following about investor behavior across different segments of the fixed-income yield curve?

1. Investors will leave their preferred maturity habitats only if compensated with a sufficient yield premium, which explains non-monotonic premia across the curve
2. The shape of the observed yield curve is essentially random from period to period and cannot be modeled with any coherent economic structure over the long run
3. The theory is mathematically identical to the pure expectations theory in every one of its testable predictions about the shape of the observed yield curve over time

Answer: A — Investors will leave their preferred maturity habitats only if compensated with a sufficient yield premium, which explains non-monotonic premia across the curve

A) Correct — preferred habitat blends segmentation with compensation-sensitive substitution. B) The theory offers economic structure. C) It differs from pure expectations.

Operating cash flow under the indirect method of the cash flow statement starts from:

1. Cash receipts collected from customers during the period, before any working capital adjustments
2. Total revenue for the period, adjusted only for the change in accounts receivable during period
3. EBITDA, adjusted only for cash interest paid and cash income taxes remitted during this period
4. Net income, adjusted for non-cash items and for changes in operating working-capital account balances

Answer: D — Net income, adjusted for non-cash items and for changes in operating working-capital account balances

A) Cash from customers is the starting point of the direct method. B) Revenue alone is not a permitted starting point under either standard. C) EBITDA is not a permitted starting point under GAAP/IFRS. D) Correct — indirect method reconciles net income to operating cash.

The fundamental accounting equation is expressed as:

1. Assets equal equity minus liabilities, rearranged to isolate the residual equity claim of the firm
2. Equity equals assets plus liabilities, combining both funding sources on the same side of equation
3. Liabilities equal assets plus equity, expressed as a claims-to-assets balancing identity for the firm
4. Assets equal liabilities plus equity, or equivalently, equity equals assets minus liabilities balance

Answer: D — Assets equal liabilities plus equity, or equivalently, equity equals assets minus liabilities balance

A) That rearrangement gets the signs wrong on liabilities. B) Assets are financed by liabilities plus equity, not summed on one side. C) The rearrangement puts liabilities on the wrong side of the equation. D) Correct — the standard balance-sheet identity.

An analyst notices that a company's deferred tax liability has grown rapidly. The MOST common cause is:

1. Accelerated tax depreciation versus straight-line book
2. Recent voluntary changes in the inventory accounting method
3. Pretax book income exceeding current taxable income figures
4. Impairment of a long-lived intangible asset in the period

Answer: A — Accelerated tax depreciation versus straight-line book

A) Correct — accelerated tax depreciation reduces current taxable income vs book, creating a reversing DTL. B) Inventory method changes have mixed and typically smaller tax effects. C) Restates the effect rather than identifies the underlying cause. D) Impairments typically create deferred tax ASSETS, not liabilities.

Return on equity (ROE) under DuPont decomposition equals:

1. Net income divided by total liabilities
2. Net income divided by dividends paid
3. Net income divided by shareholders' equity
4. Profit margin times turnover times leverage

Answer: D — Profit margin times turnover times leverage

A) Wrong denominator entirely. B) Not a standard ratio. C) Correct as simple ROE, but not the DuPont decomposition. D) Correct — three-factor DuPont identity.

What is revenue recognition?

Revenue recognized when control of goods/services transfers to the customer, at the amount the entity expects to receive (IFRS 15 / ASC 606 five-step model).

What is EBITDA?

Earnings Before Interest, Taxes, Depreciation, and Amortization. A proxy for operating cash flow, though it ignores capital expenditures and working capital changes.

What are the three main financial statements?

Income Statement (profitability), Balance Sheet (financial position), Cash Flow Statement (cash inflows/outflows).

What is a going concern assumption?

The assumption that a company will continue operating indefinitely. If going concern is in doubt, financial statements may need to be prepared on a liquidation basis.