Financial Statement Analysis — CFA Level II practice questions

Under the equity method, an investor's investment account is INCREASED by:

1. Full consolidation of the subsidiary's revenues and expenses into the investor's income statement
2. Dividends received from the investee during the period
3. The investor's proportionate share of the investee's net income
4. An impairment loss recognized on the equity investment

Answer: C — The investor's proportionate share of the investee's net income

A) Full consolidation applies to controlling interests, not the equity method used for significant influence. B) Direction reversal — dividends received reduce, not increase, the investment account under the equity method. C) Correct — the investment account increases each period by the investor's proportionate share of the investee's net income. D) Direction reversal — an impairment loss decreases, not increases, the carrying value of the investment.

Vantage Foods' Brazilian subsidiary generates nearly all of its revenue and incurs nearly all of its costs, financing, and cash flows in Brazilian reais, operating with substantial autonomy from the U.S. parent. The subsidiary's functional currency is BEST determined to be:

1. The U.S. dollar, because the parent company's presentation currency always determines the functional currency of its subsidiaries
2. The Brazilian real, because the subsidiary's primary economic environment — where it generates and spends cash — is Brazil
3. Either currency, at the parent's discretion, since functional currency is an accounting policy election rather than a fact-based determination
4. The U.S. dollar, because IFRS and US GAAP require multinational subsidiaries to use their parent's reporting currency as the functional currency

Answer: B — The Brazilian real, because the subsidiary's primary economic environment — where it generates and spends cash — is Brazil

A) A misconception — the parent's presentation/reporting currency is a separate concept from a subsidiary's functional currency; the two are not automatically the same. B) Correct — functional currency is the currency of the primary economic environment in which an entity operates, generally the currency in which it primarily generates and expends cash; the facts here (revenue, costs, financing, autonomy all in reais) point to the Brazilian real. C) A misconception — functional currency determination is a factual assessment based on economic indicators, not a discretionary policy choice management can select freely. D) A misconception — there is no blanket rule forcing the parent's currency onto autonomous foreign subsidiaries; doing so would misstate the economic substance of the subsidiary's operations.

An analyst converting a U.S. GAAP-reporting issuer's financial statements to a fully expensed R&D basis (treating capitalized development costs as expensed) should:

1. Lower ending inventory value shown
2. Partial-goodwill amount recognized
3. Operating lease straight-line cost
4. Make no adjustment in this context

Answer: D — Make no adjustment in this context

A) Lower ending inventory value shown — direction reversal. B) Partial-goodwill amount recognized — wrong goodwill method. C) Operating lease straight-line cost — related concept, not the definition. D) Correct — this identifies Make no adjustment in this context.

A US firm's subsidiary operates in a hyperinflationary economy. Under US GAAP, the parent should:

1. Service cost hits net income
2. Use the temporal method over time
3. Interest cost hits net income
4. Basic EPS calculation applied

Answer: B — Use the temporal method over time

A) Service cost hits net income — related concept, not the definition. B) Correct — this identifies Use the temporal method. C) Interest cost hits net income — related concept, not the definition. D) Basic EPS calculation applied — related concept, not the definition.

Ferrous Metal Corp has significant deferred tax assets from net operating loss carryforwards. Given a recent history of cumulative losses and no clear evidence of future taxable income, the company's auditors would MOST likely require:

1. Reclassifying the deferred tax assets as deferred tax liabilities
2. Immediately writing off the net operating losses as an extraordinary item
3. No adjustment, since deferred tax assets are always recorded at full value regardless of realizability
4. Recording a valuation allowance to reduce the deferred tax assets to the amount more likely than not to be realized

Answer: D — Recording a valuation allowance to reduce the deferred tax assets to the amount more likely than not to be realized

A) Nonsensical — DTAs and DTLs arise from opposite-direction temporary differences; a realizability concern does not convert one into the other. B) Misstates the mechanism — extraordinary-item classification is no longer used under current GAAP, and the appropriate response to realizability doubt is a valuation allowance against the DTA, not a write-off of the NOLs themselves. C) A common misconception — DTAs must be assessed for realizability, and are recorded net of a valuation allowance when realization is not more likely than not. D) Correct — under a pattern of cumulative losses and no persuasive evidence of future taxable income, a valuation allowance is required to state the deferred tax asset at the amount expected to be realized.

Under IFRS (IAS 19R), periodic pension cost in the income statement consists of:

1. Service cost plus the full expected return on plan assets, both flowing through net income
2. Only the current service cost, with all interest and remeasurement effects deferred to OCI
3. Interest cost on the gross pension obligation only, with no offset for the return on plan assets
4. Service cost plus interest expense on the NET pension liability (or income on a net pension asset), with remeasurements recognized in OCI

Answer: D — Service cost plus interest expense on the NET pension liability (or income on a net pension asset), with remeasurements recognized in OCI

A) IFRS uses net interest, not the full expected return on plan assets, in net income. B) Interest on the net liability is also included in net income under IFRS, not deferred entirely to OCI. C) IAS 19R nets the return on plan assets against interest cost rather than reporting gross interest cost alone. D) Correct — IAS 19R income statement pension cost is service cost plus net interest on the net defined benefit liability (or asset), with remeasurements in OCI.

An analyst notices a firm reports accrual ratios well above industry medians and Days Sales Outstanding (DSO) rising from 45 to 78 days. The MOST appropriate concern is:

1. A conservative accounting policy that understates the firm's reported earnings
2. Aggressive revenue recognition or channel stuffing inflating receivables and reported earnings quality
3. Improved collections efficiency, since customers are paying their invoices faster than before
4. Lower ending inventory value shown on the balance sheet

Answer: B — Aggressive revenue recognition or channel stuffing inflating receivables and reported earnings quality

A) Direction reversal — high accrual ratios and rising DSO point toward aggressive, not conservative, reported earnings. B) Correct — high accruals paired with rising DSO suggest revenue is being recognized before cash is collected, consistent with aggressive recognition or channel stuffing. C) Direction reversal — rising DSO indicates customers are paying more slowly, not faster. D) A lower ending inventory value doesn't explain rising receivables/DSO; it points to a different earnings-quality concern.

An analyst comparing two translation methods for a foreign subsidiary's financial statements notes that Method 1 flows currency gains and losses directly through net income each period, while Method 2 accumulates them in a separate equity account (cumulative translation adjustment) without affecting net income. Method 1 and Method 2 correspond, respectively, to:

1. The current rate method and the temporal method
2. The current rate method used under both IFRS and US GAAP, since the two frameworks do not differ in translation mechanics
3. The modified temporal method and the monetary/nonmonetary method
4. The temporal method and the current rate method

Answer: D — The temporal method and the current rate method

A) A direction reversal — this swaps the two methods; it is the temporal method (used when the functional currency is the parent's currency, i.e., remeasurement) that runs gains/losses through net income. B) A misconception — while the two frameworks use broadly similar translation mechanics, asserting no difference at all overstates the similarity and doesn't answer which method produces which effect. C) True but irrelevant — these are alternate labels loosely tied to the same underlying methods, not a distinct correct pairing for this question's framing. D) Correct — the temporal method (remeasurement) recognizes translation gains/losses in net income, while the current rate method (used when the local currency is the functional currency) accumulates them in OCI/CTA, bypassing net income.

In a vignette: Aurora cloud DB report shows growing CTA in OCI during currency depreciation. Functional currency?

Local currency — using current rate method. Depreciation produces translation losses → negative CTA in OCI.

What is the FCFE model?

Free Cash Flow to Equity = NI + D&A − Cap Ex − ΔWC + Net Borrowing. Discount at cost of equity. Equity value directly.

How do you account for an investment using the equity method?

Significant influence (typically 20–50% ownership). Investment recorded at cost; adjusted for share of investee earnings, dividends reduce carrying value.

What are common quality of earnings red flags?

Aggressive revenue recognition, declining receivables turnover, growing accruals, decreased capex/D&A ratio, frequent restatements, large GAAP/non-GAAP gap.