10 Common Mistakes in Financial Reporting and Analysis – CFA Level 1

We listed here for you 10 of the most common mistakes in financial reporting and analysis that CFA level 1 candidates fall in. These are 10 mistakes you wont make on exam day!

1)    Failing to distinguish between cash and accrual accounting.

Just because cash is received, it has not necessarily been earned. Accrual accounting requires the reporting to reflect the timing of the economic transaction. The main sources of confusion for candidates are with the following four terms:

  • Unearned revenue (liability): Cash received but not earned yet.
  • Accrued revenue (asset): Revenue earned but cash not received yet.
  • Prepaid expense (asset): Expense paid but not yet incurred (paid in advance).
  • Accrued expense (liability): Expense incurred but not paid yet.

2)    Forgetting to subtract preferred dividends when preferred shares are not convertible when computing diluted EPS.

Given the following diluted EPS formula:

Diluted EPS

The preferred dividends are not subtracted like in the basic EPS formula. However, this assumes that the preferred shares are dilutive AND convertible.

In order to verify if the preferred are dilutive, you check if:

Basic EPS <  EPS Preferred, then Preferred are dilutive, otherwise they are not.

Also, be careful to make sure that the question specifies that the preferred are convertible. If not, the preferred dividends should be subtracted to the earnings.

3)    Forgetting that under U.S. GAAP, the direct cash flow method has to include an indirect method reconciliation.

Candidates should remember that most companies use the indirect method. Therefore, if a company uses the direct method, it will be more difficult to compare the statement with other form. This is why whoever uses the direct method must also include a reconciliation (for comparisons purpose).

4)    Confusing capitalization of costs and capital leases.

The following summarizes the choices a firm must make:

Expenses Capitalization recording the asset on the balance sheet and amortizing
Expensing Expensed on the income statement
Leases Capital Lease Recording of the asset on the balance sheet
Operating lease Off balance sheet (lease expensed on income statement)

 

5)    Forgetting the treatment of LIFO Reserve

LIFO inventory accounting is only permitted under U.S. GAAP.

However, firms reporting using LIFO must also report a LIFO reserve which allows for financial statement users to convert to FIFO.

LIFO Reserve = LIFO Inventory – FIFO Inventory

COGSFIFO =COGSLIFO – (LIFO Reserve YEAR X – LIFO Reserve YEAR X-1)

6)    Mixing up the cycles (cash conversion, operating, net operating…).

The cash conversion cycle is also called the net operating cycle.

operating cyce

 

7)    Not knowing when to report items net of taxes on statement of earnings.

Here are the items that should be reported net of taxes on the income statement. All other items should be reported before taxes.

Net of taxes items

  • Discontinued operations
  • Extraordinary items

 

8)    Not understanding the options impact on diluted EPS.

Under the treasury method, when calculating the diluted EPS, we have to assume that all proceeds received by a firm as a result of exercising stock options will be used to purchase shares on the market.

For example, let us assume there are 100,000 options outstanding and the exercise price and market prices are $20 and $30 respectively.

First, 100,000 options will be exercise, resulting in the issuance of 100,000 shares. The firm will therefore receive 100,000x$20 = $2,000,000.

This $2,000,000 will then be used to purchase shares at the market price of $30. The reason for this is that the company is trying to minimize the dilution of existing shareholders. It can afford to purchase $2,000,000/$30 = 66,667 shares.

As a result of this repurchase, the net amount of shares issued will be 100,000 –  66,667 = 33,333 shares

9)    Failing to understand how goodwill is created and how to report it.

Goodwill is the result of an acquisition and is the excess of the purchase price over the fair market value of the target’s net assets in an acquisition. In other words:

Goodwill = Acquisition price – (FMV Target’s  Assets – FMV Target’s Liabilities)

Do not confuse goodwill with the premium which is the excess of the purchase price over the market value of the company.

Premium = Acquisition price – Market Value of Equity

Please note that the fair market value of the net assets may be different from the market value of equity since the latter depends on the stock price while the former is the value of the assets and liabilities listed on the balance sheet.

Goodwill is an intangible asset that is not amortized but rather reviewed periodically for impairment.

10)                       Forgetting what is the revaluation model.

Under IFRS, there is an alternative to the cost model in reporting long-lived assets. Under the cost model, assets are reported at their depreciated cost.

The revaluation model allows for the assets to be reported at their fair market value as long as

1-      there is an active market for that type of asset, and

2-      the fair value can be reasonably estimated.

Revaluations that result in a decrease in value are reported as a loss on the income statement.

Subsequent upward revaluations are included as gains only to the extent of the previously declared loss. Any further upward revaluation will not be reported on the income statement but will go on the shareholders’ equity section of the balance sheet under revaluation surplus.

 

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I hope this was helpful and that this will prevent you from falling into one of these common traps. We are always happy to hear your comments and feedback and if you have any pitfalls or areas that you find more difficult, post it as comment and we will answer it!

CFA® Level 1 Starter Kit

We also invite you to check out our latest CFA® Level 1 Starter Kit.

We created this CFA® Level 1 Starter Kit to help you better prepare for the upcoming CFA® exam.

CFA Level 1 - Starter Kit

We want to help you maximize your study efficiency and avoid the most common mistakes candidates make on the CFA ® Level 1 exam.

CFA ®Level 1 Starter Kit includes:

  • Top 100 Pitfalls (mistakes) to avoid on the CFA ® Level 1 exam (+50 pages PDF eBook)
  • Exam Strategies (9 pages PDF article)
  • Concentration Tips (9 page PDF article)
  • 3 study schedules : 16 weeks, 14 weeks and 10 weeks study plans (customizable in Excel)

By using the resources found in this Study Kit, you will be able to better focus on your studies knowing that you will have enough time to cover everything before the exam. You will also the learn the most frequent errors CFA® Level 1 Candidates make and how to avoid them on the exam day. Learn more.