CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
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CFA Level 1 Practice Questions for Financial Statement Analysis
1. An analyst gathers the following information about a company:

The company’s cash conversion cycle (in days) is closest to:
A. 40.
B. 59.
C. 65.
Answer: A
Evaluate overall working capital effectiveness of a company, using the operating and cash conversion
cycles, and compare its effectiveness with other peer companies. Calculate and interpret liquidity
measures using selected financial ratios for a company and compare it with peer companies.

2. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
Two companies operating in the same industry both achieved the same return on equity with the same
net sales, but the two companies were different with respect to return on total assets. Compared with
the company that had the higher return on total assets, the company with the lower return on total
assets most likely had a higher:
A. total asset turnover.
B. financial leverage multiplier.
C. proportion of common equity in its capital structure.


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Berkeley Middle East Inc.
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Answer: B
The DuPont system can be used to break down return on equity (ROE) into three components: Profit
margin, total asset turnover, and financial leverage multiplier. The first two components can be
multiplied to calculate the return on total assets (ROA). If the two companies have the same ROE, the
company with the lower ROA must have a higher financial leverage multiplier (lower proportion of
common equity in the capital structure).
3. If an analyst is preparing common-size financial statements the most appropriate way of expressing
the interest expense is as a percentage of:
A. sales.
B. total liabilities.
C. total interest-bearing debt.
Answer: A
Interest expense is an income statement account and the common-size percentage should be computed
as a percentage of sales for that company.
4. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
An analyst gathers the following information about three equipment sales that a company made at the
end of the year:

All else equal for that year, the company’s cash flow from operations will most likely be:
A. the same as net income.
B. $40,000 less than net income
C. $140,000 less than net income.



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Berkeley Middle East Inc.
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Answer: B
Equipment sale 1 results in a gain of $20,000, sale 2 results in a gain of $30,000, and By accessing this
mock exam, you agree to the following terms of use: This mock exam is provided to currently-registered
CFA candidates. Candidates may view and print the exam for personal exam preparation only. The
following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or
permitting access by anyone other than currently-registered CFA candidates; copying, posting to any
website, emailing, distributing and/or reprinting the mock exam for any purpose. sale 3 results in a loss
of $10,000. The net gain is $40,000. The amount that would be deducted from net income to determine
cash flow from operations is equal to the net gain of $40,000.
5. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
The following information is from a company’s 2008 financial statements ($ millions):

In 2008 the company declared and paid cash dividends of $5 million and recorded depreciation expense
in the amount of $25 million. The company’s 2008 cash flow from operations ($ millions) is closest to:
A. 25.
B. 30.
C. 35.
Answer: C
The change in retained earnings is $20 and dividends are paid from retained earnings. 2008 net income
equals the change in retained earnings plus any dividends paid By accessing this mock exam, you agree
to the following terms of use: This mock exam is provided to currently-registered CFA candidates.
Candidates may view and print the exam for personal exam preparation only. The following activities are
strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by
anyone other than currently-registered CFA candidates; copying, posting to any website, emailing,
distributing and/or reprinting the mock exam for any purpose.
during 2008. Depreciation expense is added to net income and the changes in balance sheet accounts
are also considered to determine cash flow from operations. $20 + 5 (dividends) + 25 (depreciation) – 5
(increase in receivables) – 3 (increase in inventory) – 7 (decrease in payables) = $35 million.



CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
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6. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
A company using the LIFO inventory method reports a LIFO reserve at year-end of $85,000, which is
$20,000 lower than the prior year. If the company had used FIFO instead of LIFO in that year, the
company’s financial statements would have reported:
A. a lower cost of goods sold, but a higher inventory balance.
B. a higher cost of goods sold, but a lower inventory balance.
C. both a higher cost of goods sold and a higher inventory balance.
Answer: C
The negative change in the LIFO reserve would increase the cost of goods sold under FIFO compared to
LIFO. FIFO COGS = LIFO COGS – Change in LIFO reserve. The LIFO reserve has a positive balance so that
FIFO inventory would be higher than LIFO inventory. FIFO inventory = LIFO inventory + LIFO reserve.
7. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
The year-end balances in a company’s LIFO reserve are $56.8 million in the company’s financial
statements for both 2007 and 2008. For 2008, the measure that will most likely be the same regardless
of whether the company uses the LIFO or FIFO inventory method is the:
A. inventory turnover.
B. gross profit margin.
C. amount of working capital.
Answer: B
The LIFO reserve did not change from 2007 to 2008. Without a change in the LIFO reserve, cost of goods
sold would be the same under both methods. Sales are always the same for both; so gross profit margin
would be the same in 2008. The FIFO inventory would be higher because the LIFO inventory and LIFO
reserve are added to compute FIFO inventory. Because the inventory balances would be different under

FIFO, inventory turnover, and net working capital would also be different under FIFO.





CFA Level 1 Practice Questions for Financial Statement Analysis

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8. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
An analyst gathers the following information about a company:

The bonds were issued at par and can be converted into 300,000 common shares. All securities were
outstanding for the entire year. Diluted earnings per share is closest to:
A. $1.05.
B. $1.26.
C. $1.36.
Answer: B
Dividends of $140,000 (0.07 x 2,000,000) should be deducted from net income to determine the amount
available to common shareholders: $1,360,000 = (1,500,000 – 140,000). Basic EPS would be $1,360,000 /
1,000,000 or $1.36 per share. Diluted EPS would consider the convertible bonds if they were dilutive.
Interest on the bonds is $400,000 and the after-tax amount add back to net income is $400,000 (1 30) =
$280,000. Diluted EPS, assuming conversion, is ($1,360,000 + 280,000) / (1,000,000 +300,000) =
1,640,000/1,300,000= $1.26 per share. The bonds are dilutive.
9. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
At the beginning of the year, two companies issued debt with the same market rate, maturity date, and
total face value. One company issued coupon-bearing bonds at par and the other company issued zero-
coupon bonds. All other factors being equal for that year, compared with the company that issued par

bonds, the company that issued zero-coupon debt will most likely report:
A. higher cash flow from operations but not higher interest expense.
B. both higher cash flow from operations and higher interest expense.
C. neither higher cash flow from operations nor higher interest expense.
Answer: A
When a company issues a zero-coupon bond, cash flow from operations is overstated over the life of the
bond. Interest expense is recorded for income statements purposes, but is added back in the statement
of cash flows as a non-cash adjustment to cash flow from operations.

CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
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10. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
Which of the following is the simplest way for a company to increase its reported operating cash flow?
A. Record sales on a bill-and-hold basis.
B. Slow down the rate of payment to suppliers.
C. Use a third party financial institution to pay suppliers.
Answer: B
Slowing down the rate or payments to suppliers is the simplest way to increase reported operating cash
flow.
11. When the financial statements materially depart from accounting standards and are not fairly
presented, the audit opinion would be a(n):
A. adverse opinion.
B. qualified opinion.
C. disclaimer of opinion.
Answer: A
An adverse opinion occurs when the financial statements materially depart from accounting standards
and are not fairly presented. A qualified opinion is one in which there is some limitation or exception to

accounting standards.
12. An issue subject to a vote at a stockholders’ meeting is presented in a(n):
A. interim report.
B. proxy statement.
C. management statement of responsibility.
Answer: B
Proxy statements are prepared and distributed to shareholders on matters that are to be put to a vote
at shareholder meetings.



CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
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13. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
A company acquires a manufacturing facility in which it will produce toxic chemicals. The cost of the
facility (exclusive of the underlying land) is $25 million and it is expected to provide a 10-year useful life,
after which time the company will demolish the building and restore the underlying land. The cost of
this restoration and cleanup is estimated to be $3 million at that time. The facility will be amortized on a
straight-line basis. The company’s discount rate associated with this obligation is 6.25 percent. The total
expense that will be recorded in the first year associated with the asset retirement obligation on this
property is closest to:
A. $163,618.
B. $224,945.
C. $265,879.
Answer: C
The PV of the future cleanup costs = 1,636,183 (FV = 3,000,000; N = 10; I/Y = 6.25; PMT = 0; CPT PV). The
firm will record asset retirement costs of $1,636,183 as part of the cost of the property and a

corresponding ARO liability of $1,636,183. The asset retirement costs will be amortized at the same rate
as the property (10 years, straight-line) and an accretion expense representing the change in the ARO
liability will also arise.
14. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
A company receives a payment of $10,000 on 1 December, for rent on a property for December and
January. On receipt, they correctly record it as cash and unearned revenue. If at 31 December, their
year-end, they failed to make an adjusting entry related to this payment, ignoring taxes, what is the
effect on the financial statements for the year?
A. Assets are overstated by $5,000 and Liabilities are overstated by $5,000
B. Assets are overstated by $5,000 and Owner’s equity is overstated by $5,000
C. Liabilities are overstated by $5,000 and Owners’ equity is understated by $5,000
Answer: C
The company should have made an adjusting entry to reduce the Unearned revenue account (a liability)
by $5,000 and increase Revenue, (and hence net income and retained earnings) by $5,000. As the
company failed to make the adjusting entry the liabilities are overstated and owners’ equity is
understated.
CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
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15. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. An
analyst gathers the following information from a company’s accounting records (all figures in
thousands):

The analyst’s estimate of net income ($ thousands) for 2008 is closest to:
A. 650.
B. 850.
C. 1,050.
Answer: C

Total assets = liabilities + owner’s equity. Owner’s equity = $5,250– 2,200= 3,050. Owners equity =
contributed capital + ending retained earnings. Ending retained earnings = 3,050– 1,400= 1,650. Ending
retained earnings = beginning retained earnings + net income – dividends. 1,650= 800 + net income –
200; Net income = $1,050
16. Which of the following is least likely to be a characteristic of an effective financial reporting
framework?
A. Consistency.
B. Comparability.
C. Comprehensiveness.
Answer: B
The characteristics of a coherent financial reporting network are transparency, comprehensiveness and
consistency. Comparability is a qualitative characteristic of financial statements.





CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
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17. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
An analyst gathers the following data about a company and the industry in which it operates:

Which of the following conclusions is most reasonable? Compared to the industry, the company:
A. has the same cost structure and net profit margin.
B. has a lower gross profit margin and spends more on its operating costs.
C. is better at controlling product costs, but less effective at controlling operating costs.
Answer: C


18. A European based company follows IFRS (International Financial Reporting Standards) and
capitalizes new product development costs. During 2008 they spent €25 million on new product
development and reported an amortization expense related to a prior year’s new product development
of €10 million. Other information related to 2008 is as follows:

An analyst would like to compare the European company to a similar U.S. based company and has
decided to adjust their financial statements to U.S. GAAP. Under U.S. GAAP, and ignoring tax effects,
the cash flow from operations (€ millions) for the company would be closest to:
A. 265.
B. 275.
CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
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C. 290.
Answer: A
Compute and describe the effects of capitalizing versus expensing on net income, shareholders’ equity,
cash flow from operations, and financial ratios including the effect on the interest coverage ratio of
capitalizing interest costs. Explain the circumstances in which software development costs and research
and development costs are capitalized
If all development costs had been expensed then net income would be reduced by the amount spent,
and increased by the amortization of the previously capitalized amounts: 225 – 25 + 10 = 210 million.
CFO would be lower by the amount spent on development 290 – 25 = 265 million. Note: The
amortization of previous development costs is a non-cash expense so does not affect cash flow.
19. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
Which of the following best describes taxes payable?
A. Total liability for current and future taxes.
B. Tax return liability resulting from current period taxable income.

C. Actual cash outflow for income taxes including payments (refunds) for other years.
Answer: B
Taxes payable is the current liability resulting from the current period taxable income based on the
company’s tax rate and the portion of its income that is subject to income taxes under the tax laws of
the jurisdiction.
20. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
A company is considering issuing either a straight coupon bond or a coupon bond with warrants
attached. The proceeds from either issue would be the same. If the firm issues the bond with warrants
attached instead of the straight coupon bond, which of the following ratios will most likely be lower for
the bond with warrants?
A. Return on assets.
B. Debt to equity ratio
C. Interest coverage ratio.
Answer: B
The portion of the proceeds attributable to the warrants would be classified as equity, thus the portion
classified as a liability would be smaller (lower). Therefore the debt-to-equity ratio will be lower, for the
CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
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bonds with warrants. EBIT would be the same regardless of financing method; the coupon on the bond
with warrants attached would be lower if the two issues provided the same proceeds, so the interest
coverage would be higher for a bond with warrants attached. Since interest expense would be lower
for a bond with warrants attached, Net Income would be higher and ROA would be higher.
21. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
An analyst is forecasting EPS for a company. She prepares the following common sized data from its
recent annual report and estimates sales for 2009.

The capital structure of the company has not changed and the company has no short-term interest

bearing debt outstanding. The projected net income (in $ millions) for 2009 is closest to:
A. 162.8.
B. 164.9.
C. 167.4.
Answer: C
The cost of goods sold and operating expenses are constant over the two-year period and they can
reasonably be used to forecast 2009. Interest expense is declining as a percent of sales, implying it is a
fixed cost. Conversion into dollars for each year shows what interest expense has been; 2008 =$80
(3.72% x 2,150); 2007=$80 (4.02 x 1,990) and that would be a reasonable projected amount to use. The
restructuring charge should not be included as it is a non-recurring item. The tax rate, 35%, is given.
Sales $2,250.00 COGS (45%) 1,012.50 Operating expenses (40%) 900.00 Interest expense 80.00
Pretax margin 257.50 Tax (35%) 90.1 Net Income 167.40



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Berkeley Middle East Inc.
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22. The unrealized gains and losses arising from changes in the market value of available-for-sale
securities are reported under U.S. GAAP and International Financial Reporting Standards (IFRS) in the:
A. equity section for both.
B. equity section for U.S. GAAP and the income statement for IFRS.
C. income statement for U.S. GAAP and the equity section for IFRS.
Answer: A
Under both U.S. GAAP and IFRS the unrealized gains and losses arising from carrying available-for-sale
securities at market value are reported in equity as part of accumulated other comprehensive income.
23. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A
company records the following two transactions:


Which of the above transactions will most likely give rise to a deferred tax liability on the balance sheet?
A. I only.
B. II only.
C. Both I and II.
Answer: B
II represents a deferred tax liability: The accounts receivable for financial statement purposes has a
carrying value of €500,000 but with a tax base of €0. The temporary difference creates a deferred tax
liability. Alternatively, accounting income tax expense exceeded taxes payable and the firm expects to
eliminate this difference over the course of future operations. Item I represents a deferred tax asset:
Rent received in advance creates a liability on the financial statements with a carrying value of €300,000
but with a tax base of €0. The temporary difference creates a deferred tax asset. Alternatively an excess
amount has been paid for income taxes based on the cash received (taxable income exceeded
accounting income) and the company expects to recover this difference during the course of future
operations.


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24. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
On 1 January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor
with the following terms:

The total affect on 2008 pre-tax income for the lessor from this lease is closest to:
A. $32,143.
B. $75,000.
C. $82,519.

Answer: C
This is a sales type lease: the lease period covers more than 75% of its useful life (6/7=85.7%) and the
asset is on its books at less than the present value of the lease payments ($357,490) (PMT = $75,000,
N=6, i=7%). The firm must have acquired or manufactured the asset if it is recorded at less than the
present value of the lease payments. The income in the first year will therefore consist of the gross
profit on the sale (357,490-300,000)=57,490 plus interest revenue from financing the lease = 25,024(see
below)
Total income = 57,490 + 25,024 = 82,514
25. An analyst finds information about significant uncertainties affecting a company’s liquidity, capital
resources and results of operations in the:
A. notes to the financial statements.
B. balance sheet and income statement.
C. management discussion and analysis.
Answer: C
Management must highlight any favorable and unfavorable trends and identify significant events and
uncertainties that affect the company’s liquidity, capital resources and results of operations in the
management discussion and analysis (MD&A).

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26. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
Which of the following is least likely to be classified as a financial statement element?
A. Asset.
B. Revenue.
C. Net income.
Answer: C
Net income is not an element of the financial statements, but the net result of revenues less expenses.

The elements are: assets, liabilities, owners’ equity, revenue and expenses.
27. An analyst prepares common-size balance sheets for two companies operating in the same industry.
The analyst notes that both companies had the same proportion of current liabilities, long-term
liabilities, and shareholders’ equity and the following ratios:

The most reasonable conclusion is that, compared with Company 2, Company 1 had a:
A. higher percentage of assets associated with inventory.
B. higher percentage of assets associated with accounts receivable.
C. lower percentage of assets associated with marketable securities.
Answer: A
The current ratio includes inventory but the quick ratio does not. (Current ratio is higher than quick
ratio and quick ratio is higher than cash ratio.) The quick ratio includes accounts receivable but the cash
ratio does not. The denominator for all three ratios is current liabilities, which are the same proportion
for both companies. The difference in ratios is therefore created by inventory and accounts receivable.
Company 1 has the higher percentage of inventory because the difference between the current ratio
and quick ratio is greater for that company. Company 2 had the higher percentage of accounts
receivable because the difference between the quick ratio and the cash ratio is greater for Company 2.


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28. If a company has a current ratio of 2.0, the effect of repaying $150,000 in short-term borrowing will
most likely decrease:
A. the current ratio, but not the cash flow from operations.
B. the cash flow from operations, but not the current ratio.
C. neither the current ratio nor the cash flow from operations.
Answer: C

The repayment of short-term debt would reduce cash flow from financing, not cash flow from
operations. Any time the current ratio is above 1, equal changes in a current asset and a current liability
will result in an increase in the current ratio: if current assets = 550 and current liabilities are 275,
current ratio = 550/275 = 2.0. After the bank borrowing has been paid, the ratio becomes (550-
150)/(275-150) = 3.2. Had the ratio initially been below 1, current assets = 250 and current liabilities are
275, current ratio = 250/275 = 0.91, the equal change in current assets and liabilities would decrease the
current ratio: 100/125=0.80.
29. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
At the end of the year, a company sold equipment for $30,000 cash. The company paid $110,000 for
the equipment several years ago and had recorded accumulated depreciation of $70,000 at the time of
its sale. All else equal, the equipment sale will result in the company’s cash flow from:
A. investing activities increasing by $30,000.
B. investing activities decreasing by $10,000.
C. operating activities being $10,000 less than net income.
Answer: A
The book value of the equipment at the time of sale is $110,000 - $70,000 = $40,000. The proceeds are
$30,000; therefore a loss of $10,000 is reported on the income statement. The loss reduces net income,
but it is a non-cash amount, so is added back to net income in the calculation of the cash from
operations. Therefore, cash from operations is higher than net income, not lower. The total amount of
the proceeds, $30,000, is the cash inflow from the transaction and is shown as a cash inflow from
investing activities.




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30. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
A company reports net income of $800,000 for the year. The table below indicates selected items which
were included in net income and their associated tax status.

The company’s tax rate is 35 percent. The company’s current income taxes payable (in $) is closest to:
A. 206,500.
B. 276,500.
C. 360,500.
Answer: B

31. An analyst gathers the following annual information ($ millions) about a company that pays no
dividends and has no debt:

The company’s annual free cash flow to equity ($ millions) is closest to:

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A. 53.1.
B. 58.4.
C. 61.6.
Answer: C
Free cash flow to equity in a company without any debt is equal to cash flow from operations (CFO) less
capital expenditures. CFO = net income + depreciation + loss on sale of equipment + decrease in
accounts receivable – increase in inventories + increase in accounts payable. (The loss on sale of
equipment is added back when calculating CFO. It would have been deducted in the calculation of net
income but the loss is not the cash impact of the transaction (the proceeds received, if any, would be
the cash effect) and cash flows related to equipment transactions are investing activities, not operating

activities. CFO = 45.8 + 18.2 +1.6 + 4.2 – 3.4 +2.5 = $68.9 million $68.9 – $7.3 = $61.6 million free cash
flow to equity.
32. Which of the following statements best describes the level of accuracy provided by a standard audit
report with respect to errors? The audited financial statements are:
A. fully assured to be free of material errors.
B. reasonable assured to be free of all errors.
C. reasonable assured to be free of material errors.
Answer: C
Audits provide reasonable assurance that the financial statements are fairly presented, meaning that
there is a high degree of probability that they are free of material error, fraud or illegal acts.
33. Making any necessary adjustments to the financial statements to facilitate comparison with respect
to accounting choices is done in which step of the financial statement analysis framework?
A. Collect data.
B. Process data.
C. Analyze/interpret the processed data.
Answer: B
Making any adjustments is part of the processing data step. Commonly used data bases (part of the
collection phase) do not make adjustments for differences in accounting choices.

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34. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
For the most recent year a manufacturing company reports the following items on their income
statement:
Interest expense $62,500 Loss on disposal of fixed assets $50,000 Realized gain on sale of available-for-
sale securities $17,750
Which of the items is classified as an operating item in the company’s income statement?

A. Interest expense.
B. Loss on disposal of fixed assets.
C. Realized gain on sale of available-for-sale securities.
Answer: B
The loss on the disposal of fixed assets is an unusual or infrequent item but it is still part of normal
operating activities. The interest expense is the result of financing activities and would be classified as a
nonoperating expense by nonfinancial service companies. The realized gain on sale of available for sale
securities is an investing activity and would also be classified as a nonoperating gain by a manufacturing
company.
35. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
The following information is available from the accounting records of a company as at 31 December
2008 (all figures in $ thousands):

The working capital for the company (in $ thousands) is closest to:
A. 64.
B. 72.
C. 176.
Answer: A
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36. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
During late December 2008 Company A acquires a small competitor, Company
B. During the evaluation of the acquisition it is determined that the customer lists of Company B have a
fair value of $50,000. Company A has spent $15,000 during the year updating and maintaining its own
customer lists. What will be the value of the customer list intangible asset on Company A’s 31
December 2008 consolidated financial statements?

A. $15,000.
B. $50,000.
C. $65,000.
Answer: B
The purchased customer list is an identifiable intangible because it can be sold separately from the
company and it would be recorded at its fair market value, the amount paid for it in the acquisition,
$50,000. The amount spent by Company A on its own lists, $15,000, would have to be expensed because
internally generated intangibles are not capitalized.
37. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
A company has equipment with an original cost of $850,000, accumulated amortization of $300,000 and
5 years of estimated remaining useful life. Due to a change in market conditions the company now
estimates that the equipment will only generate cash flows of $80,000 per year over its remaining useful
life. The company’s incremental borrowing rate is 8 percent. Which of the following statements
concerning impairment and future return on assets (ROA) is most accurate? The asset is:
A. impaired and future ROA increases.
B. impaired and future ROA decreases.
CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
Url: www.berkeleyme.com Email: Tel: 050-4401915
C. not impaired and future ROA increases.
Answer: A
The equipment is impaired. NBV = $550,000 which is greater than the sum of the undiscounted cash
flows 5 yrs x $80,000 = $400,000. The company’s future ROA will increase. Once the asset is written
down, there will be lower depreciation charges, which will increase net income, and a lower carrying
value of assets, which decreases total assets. Both factors would increase any future ROA.
38. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
On 1 January 2008 a company enters into a lease agreement to lease a piece of machinery as the lessor
with the following terms:


Which of the following best describes the classification of the lease on the company’s financial
statements for 2008?
A. Operating lease.
B. Sales type lease.
C. Direct financing lease.
Answer: B It is a sales type lease: the lease period covers more than 75% of its useful life (5/6=83.3%)
and the asset is on its books at less than the present value of the lease payments ($199,635) (PMT =
$50,000, N=5, i=8%). The firm must have acquired or manufactured the asset if it is recorded at less than
the present value of the lease payments.
39. Which of the following is the most useful to an analyst assessing the credit worthiness of a
company? Information related to:
A. operating cash flow.
B. the scale and diversity of a company’s operations.
C. operational efficiency of the company’s operations.


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Berkeley Middle East Inc.
Url: www.berkeleyme.com Email: Tel: 050-4401915
Answer: A
Credit analysis is concerned with a company’s debt-paying ability. Returns to creditors are normally paid
in cash, so the company’s ability to generate cash internally is the most important factor in credit
analysis.
40. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
A company acquires some new depreciable assets. Which of the following combinations of estimated
salvage value and useful life will most likely produce the highest net profit margin?
A. low salvage value estimates and long average lives.

B. high salvage value estimates and long average lives.
C. high salvage value estimates and short average lives.
Answer: B
A high salvage value estimate reduces the depreciable base and thus depreciation expense; long average
lives reduce the annual depreciation expense for any given depreciable base. The combination of the
two would result in the lowest depreciation expense which leads to the highest net income and profit
margins.
41. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
An analyst gathers the following information about a company ($ millions):

If the company uses the FIFO inventory method instead of LIFO, the company’s 2008 gross profit margin
is closest to:
A. 22.9%.
B. 29.8%.
C. 33.2%.



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Page 22 of 100
Berkeley Middle East Inc.
Url: www.berkeleyme.com Email: Tel: 050-4401915
Answer: C


42. Which of the following will most likely be an incentive for management to underreport earnings?
A. Meeting analysts’ expectations.
B. Contract negotiations with unions.
C. Meeting restrictive debt covenants.

Answer: B
Management is most likely to try and report lower earnings when negotiating concessions from a union.
43. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
A company uses the LIFO inventory method, but most of the other companies in the same industry use
FIFO. Which of the following best describes one of the adjustments that would be made to the
company’s financial statements to compare it with other companies in the industry? The amount
reported for the company’s ending inventory should be:
A. increased by the ending balance in its LIFO reserve.
B. decreased by the ending balance in its LIFO reserve.
C. increased by the change in its LIFO reserve for that period.
Answer: A
LIFO Reserve = FIFO Inventory – LIFO Inventory Adding the ending balance in the LIFO reserve to the
LIFO inventory would equal the ending balance for inventory on a FIFO basis.



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Berkeley Middle East Inc.
Url: www.berkeleyme.com Email: Tel: 050-4401915
44. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
An analyst gathers the following information about a company:

Using the treasury stock method, the number of incremental shares used to compute diluted earnings
per share is closest to:
A. 5,000.
B. 15,000.
C. 20,000.
Answer: A

Diluted EPS is calculated using the treasury stock method that considers what would be the effect if the
options or warrants had been exercised. Only options or warrants that are in-the-money are included, as
out-of-the-money options would not be exercised. Therefore only the warrants are dilutive: their
exercise price is below the average market price of the stock. Using the treasury stock method, the
number of new shares issued on exercise is reduced by the number of shares that could be purchased
with the cash received upon exercise of the warrants: 20,000($30) = $600,000 in proceeds. $600,000 /
$40 = 15,000 shares treasury stock. Incremental shares using the treasury stock method = 20,000 –
15,000 = 5,000.
45. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
At the beginning of the year, a lessee company enters into a new lease agreement that is correctly
classified as a finance lease, with the following terms:

With respect to the effect of the lease on the company’s financial statements in the first year of the
lease, which of the following is most accurate? The reduction in the company’s:
A. pretax income is $72,096.
B. cash flow from financing is $56,742.
C. cash flow from operations is $72,096.
CFA Level 1 Practice Questions for Financial Statement Analysis

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Berkeley Middle East Inc.
Url: www.berkeleyme.com Email: Tel: 050-4401915
Answer: B
The present value of the lease is $360,477.62. (n = 5, I = 12%, PMT = $100,000) 12% of the original PV is
$43,257.31 and represents the interest component of the payment in the first year. The difference
between the annual payment and the interest is the amortization of the lease obligation included in
cash flow from financing. $100,000 – 43,257.31 = $56,742.69. Depreciation is $360,477.62 / 5 or
$72,095.52 so the total reduction in pretax income would be interest plus depreciation or $115,352.83.
Cash flow from operations would be reduced by the amount of the interest only because the
depreciation would be added back to determine cash flow from operations.

46. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
The following information relates to a profitable company that offers a warranty on a new product
introduced in 2008:

If the company’s tax rate is 35 percent, which of the following most accurately describes the deferred
tax recorded in 2008 with respect to the new product warranty?
A. Deferred tax asset of $35,000.
B. Deferred tax asset of $65,000.
C. Deferred tax liability of $35,000.
Answer: A
For financial statement purposes, the warranty expense recorded in 2008 is greater than the cash
expense they incurred (and that is allowed as a deduction for income tax purposes), resulting in a
warranty liability for financial statement purposes, but not for tax purposes. As the carrying amount of
the liability is greater than the tax base, the $100,000 temporary difference will give rise to a $35,000
(100,000 x 0.35) deferred tax asset.
47. Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted.
At the beginning of the year, a company issues a $1,000 face value, semiannual coupon, bond with an 8
percent coupon rate maturing in 10 years. The annual market rate of interest at issuance was 12
percent. The initial liability recorded for this bond is closest to:
A. $771.
B. $774.
C. $1,000.
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Berkeley Middle East Inc.
Url: www.berkeleyme.com Email: Tel: 050-4401915
Answer: A
The liability recorded is based on market rates of interest when the bond is issued and not the coupon
rate on the bond. The market value of the bond at issuance was $770.60. (FV=1,000, PMT=40, N=20,

I=6.0).
48. Financial reporting standards are most likely enforced by:
A. both standard-setting bodies and regulatory bodies.
B. regulatory authorities, such as the SEC and IOSC, only.
C. standard-setting bodies, such as the FASB and IASB, only.
Answer: B
49. According to the International Financial Reporting Standards framework, which of the following
qualities of financial information is least likely to improve its reliability?
A. Neutrality
B. Consistency
C. Substance over form
Answer: B
The IFRS framework identifies five factors that contribute to reliability: faithful representation,
substance over form, neutrality, prudence and completeness. Consistency is not one of them.
50. The following information is available about a company ($ millions):

During 2009 the company most likely decreased the:
A. proportion of sales made on a cash basis.
B. inventory, anticipating lower demand for its products in 2010.
C. proportion of interest-bearing debt relative to trade accounts payable.