Financial Reporting and Analysis
Domain 2 - Financial Reporting and Analysis
This domain tests your ability to read the three financial statements together, adjust reported numbers for accounting choices, and judge earnings quality. Questions often ask which ratio or cash-flow line changes when a firm changes an accounting policy, or which adjustment makes two firms comparable.
Core rules
- Revenue recognition: Apply the five-step model: identify the contract, identify performance obligations, determine transaction price, allocate price to obligations, and recognize revenue when control transfers.
- Expense capitalization: Capitalizing an expenditure creates an asset and depreciation or amortization. It raises current profit and operating cash flow relative to expensing, while investing cash flow falls.
- Leases: A finance lease puts a right-of-use asset and lease liability on the balance sheet; payments split into interest and principal. An operating lease also recognizes a liability under current standards, but expense recognition is straight-line.
- Deferred taxes: Temporary differences create deferred tax assets or liabilities. A valuation allowance reduces a deferred tax asset when realization is not more likely than not.
- Quality signals: Watch accruals, non-recurring items, inventory liquidations, pension assumptions, and changes in estimates.
Worked example
A firm spends 100 on a project with a five-year life. If expensed immediately, pre-tax profit falls by 100. If capitalized, annual depreciation is 20, so year-one profit falls by only 20; assets at year-end are 80 higher, and CFO is 100 higher because the cash outflow is investing rather than operating. Ignoring tax, net income is 80 higher in year one under capitalization, but free cash flow is unchanged: CFO rises by 100 and capex rises by 100. The trap is to conclude that capitalization creates value. It mainly shifts timing and classification.
Traps that cost marks
- Comparing ratios across firms without adjusting for LIFO versus FIFO.
- Treating a deferred tax asset as cash-equivalent without assessing realization.
- Missing that a lease reclassification changes EBITDA but not total cash paid.
- Ignoring diluted shares, convertible securities, and stock options in EPS.
- Calling a gain from an asset sale recurring operating income.