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CFA Level II Updated
How do analysts distinguish between adjusting and non-adjusting subsequent events, and what is the financial statement impact of each?
Adjusting subsequent events provide evidence of conditions that existed at the balance sheet date and require revision of financial statement amounts. Non-adjusting events arise after the reporting date and are disclosed in notes without changing reported figures.
What are the key red flags in related party transactions, and how should analysts adjust their valuation for excessive RPT exposure?
Related party transaction red flags include pricing opacity, volume concentration with related entities, timing around reporting periods, and complex ownership structures. Analysts should restate RPTs at market prices, adjust normalized earnings, and consider a governance discount for high-exposure companies.
What is round-tripping revenue, and how do circular transactions create fictitious sales that survive initial audit procedures?
Round-tripping creates fictitious revenue through circular cash flows between cooperating entities. Detection requires netting cash flows with each counterparty, scrutinizing reciprocal contracts of similar magnitude, and investigating the business substance of purchased goods or services.
What is channel stuffing, and which financial metrics best reveal this form of revenue manipulation?
Channel stuffing inflates revenue by shipping excess inventory to distributors under favorable terms. Key detection signals include spiking DSO, revenue-to-cash-flow divergence, and alternating strong-weak quarterly revenue patterns.
How does classification shifting manipulate earnings quality, and what red flags should analysts look for in the income statement?
Classification shifting inflates core operating income by reclassifying recurring expenses as non-recurring special items, leaving total net income unchanged. Analysts should watch for persistent special charges, margin expansion without revenue growth, and divergences between operating income and cash flow.
What is the Modigliani-Miller dividend irrelevance theorem, and under what assumptions does it hold?
The Modigliani-Miller dividend irrelevance theorem states that in perfect capital markets, firm value is unaffected by dividend policy. The theory holds under assumptions of no taxes, no transaction costs, no asymmetric information, no agency costs, and fixed investment policy.
How does the abandonment option protect downside risk, and what determines the optimal time to exercise it?
The abandonment option acts as a put, allowing management to shut down a failing project and recover salvage value. Abandon when the salvage value exceeds the present value of remaining cash flows. This downside protection can transform marginal rejects into clear accepts.
What is jackknife estimation, and how does it reduce bias compared to standard plug-in estimators?
The jackknife systematically removes one observation at a time, computes the statistic on each reduced sample, and uses these leave-one-out estimates to detect and correct bias. It is deterministic unlike bootstrapping and particularly effective for bias reduction.
What is structural subordination, and why are holding company creditors at a disadvantage compared to operating subsidiary creditors?
Structural subordination occurs when holding company creditors have a junior claim relative to operating subsidiary creditors because the parent accesses subsidiary assets only as an equity holder — the most junior claim in bankruptcy. Both may issue senior unsecured debt, but the HoldCo recovery is systematically lower.
How does the Merton model derive a firm's probability of default from its equity value and volatility?
The Merton model treats equity as a call option on firm assets and solves simultaneous equations using observable equity value and volatility to derive unobservable asset value and asset volatility. The distance to default measures how many standard deviations assets are above the default boundary.
What is the theoretical relationship between CDS spreads and equity prices, and how do traders exploit divergences?
CDS spreads and equity prices are negatively correlated through the structural credit model: both reflect distance to default but through different instruments. When the two markets diverge, capital structure arbitrageurs trade the convergence by going long one and short the other.
How is the Shiller CAPE ratio calculated, and what are its strengths and limitations for market valuation?
The CAPE ratio divides the current real price of the market by the average real earnings over the prior 10 years, smoothing business cycle effects. While historically predictive of long-term returns, valid criticisms include accounting changes, the shift toward buybacks, and sector composition evolution.
How do you calculate a cash-adjusted P/E ratio, and why does it matter for companies with large cash balances?
Cash-adjusted P/E removes net cash per share from the stock price and after-tax interest income from EPS to isolate the multiple on the operating business. For cash-heavy companies, this reveals a meaningfully lower valuation than the headline P/E suggests.
What does the EV/Invested Capital ratio tell us, and how does it relate to economic value creation?
EV/Invested Capital measures how much the market pays per dollar of capital deployed. When ROIC exceeds WACC, EV/IC exceeds 1.0, indicating value creation. The ratio formally equals (ROIC - g) / (WACC - g), directly linking valuation to economic profit.
How is an earn-out (contingent consideration) measured at acquisition and subsequently remeasured?
Contingent consideration is recorded at fair value on the acquisition date, typically using probability-weighted scenarios discounted to present value. After acquisition, changes in fair value are recognized in profit or loss — not as adjustments to goodwill — creating earnings volatility that analysts usually adjust out.
Is an order or production backlog recognized as a separate intangible asset in a business combination?
An order backlog is recognized as a separate intangible asset in a business combination because it arises from contractual rights — binding purchase orders. It is valued using the excess earnings on committed orders, discounted to present value, and amortized over the fulfillment period.
How is a technology-based intangible asset identified and valued in a business combination?
Technology-based intangibles are valued using the relief-from-royalty method when externally licensed, multi-period excess earnings when they are the primary revenue driver, or replacement cost less obsolescence when they serve as supporting assets. Useful life is determined by the shorter of legal protection and economic viability.
How does Romer's endogenous growth theory explain sustained growth without relying on exogenous technology?
Romer's endogenous growth theory explains sustained growth through deliberate R&D investment and knowledge spillovers. Unlike physical capital, knowledge is non-rival and does not face diminishing returns, allowing economies that invest heavily in innovation to grow faster permanently.
What is an iron butterfly, and how does it differ from an iron condor in terms of construction and profit potential?
An iron butterfly sells an ATM straddle and buys OTM wings for protection, creating higher maximum profit but a narrower profit zone compared to an iron condor. Maximum profit occurs only if the underlying closes exactly at the short strike at expiration.
How are other post-employment benefits (OPEB) accounted for, and why are they often larger than pension obligations?
OPEB covers retiree healthcare and other non-pension benefits, accounted for similarly to DB pensions but typically unfunded and subject to volatile healthcare cost inflation. The accumulated post-retirement benefit obligation (APBO) often exceeds pension liabilities because plans lack dedicated assets.
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