Ch2. CFA Level I — Ethics, Quantitative Methods, and Financial Analysis

Level I Strategy Overview

CFA Level I tests 10 subject areas across 180 questions. Among them, Ethics and Professional Standards, Quantitative Methods, and Financial Statement Analysis (FSA) hold the highest weight and are most critical both for exam performance and real-world practice.

These three subjects together account for approximately 35–45% of the exam. Ethics in particular carries a minimum score threshold — failing to clear it can result in overall failure regardless of performance in other subjects.

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Subject 1: Ethics and Professional Standards

Weight and Importance

• Exam weight: 15–20% (highest single weight at Level I)
• Format: Situational judgment — candidates read scenarios and determine whether professional standards have been violated
• Appears on all three levels: Ethics accounts for 10–20% at each of Levels I, II, and III

Standards of Professional Conduct

The CFA Institute’s ethical framework consists of seven major Standards (I through VII).

Standard I — Professionalism

• I(A) Knowledge of the Law: comply with applicable laws; apply the stricter standard when rules conflict
• I(B) Independence and Objectivity: avoid compromising judgment due to external pressure
• I(C) Misrepresentation: no false statements or material omissions
• I(D) Misconduct: no fraud, dishonesty, or acts of moral turpitude

Standard II — Integrity of Capital Markets

• II(A) Material Nonpublic Information: no trading or inducing others to trade on inside information
• II(B) Market Manipulation: no actions that create false prices or mislead participants

Key Test — What Qualifies as Material Nonpublic Information?
1. Materiality: information that a reasonable investor would likely consider significant
2. Nonpublic: not yet available to the investing public
→ Both conditions must be met for trading/recommending to be prohibited

Standard III — Duties to Clients

• III(A) Loyalty, Prudence, and Care: prioritize client interests
• III(B) Fair Dealing: treat all clients equitably
• III(C) Suitability: match recommendations to client risk tolerance and objectives
• III(D) Performance Presentation: report accurate investment results
• III(E) Preservation of Confidentiality: protect client information

Standard IV — Duties to Employers

• IV(A) Loyalty: act in employer’s interest (but need not follow unethical instructions)
• IV(B) Additional Compensation: permissible with employer and client consent
• IV(C) Responsibilities of Supervisors: take steps to prevent subordinates from violating rules

Standard V — Investment Analysis, Recommendations, and Actions

• V(A) Diligence and Reasonable Basis: hold sufficient analytical basis before recommending
• V(B) Communication: distinguish fact from opinion; include material information
• V(C) Record Retention: maintain records supporting analysis and decisions

Standard VI — Conflicts of Interest

• VI(A) Disclosure of Conflicts: disclose conflicts in advance
• VI(B) Priority of Transactions: execute client orders before personal trades
• VI(C) Referral Fees: disclose compensation received for referring clients

Standard VII — Responsibilities as a CFA Institute Member or Candidate

• VII(A) Conduct as Participants in CFA Institute Programs: report violations
• VII(B) Reference to CFA Institute: no misrepresentation of the designation or program

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Subject 2: Quantitative Methods

Weight and Importance

• Exam weight: 6–9%
• Role: Foundational toolkit used throughout all other subjects
• Level II connection: Regression analysis from Quant is directly applied in Level II financial analysis

Core 1: Time Value of Money

The conversion between present value (PV) and future value (FV) is a concept that runs through the entire CFA curriculum.

Core Formulas:

FV = PV × (1 + r)^n
PV = FV / (1 + r)^n

Where:
r = periodic interest rate (discount rate)
n = number of periods

Annuity PV:
PV = PMT × [1 - (1 + r)^(-n)] / r

Perpetuity PV:
PV = PMT / r

BA II Plus calculator: Master 5 variables — N (periods), I/Y (rate), PV (present value), PMT (payment), FV (future value). Enter any 4 and solve for the 5th.

Core 2: Probability and Expected Return

Expected Return:
E(R) = Σ [P(Ri) × Ri]

Variance:
σ² = Σ [P(Ri) × (Ri - E(R))²]

Standard Deviation:
σ = √σ²

Covariance:
Cov(A, B) = Σ [P × (RA - E(RA)) × (RB - E(RB))]

Correlation:
ρ(A, B) = Cov(A, B) / (σA × σB)
Range: -1 ≤ ρ ≤ +1

Diversification benefit: the lower the correlation, the greater the risk reduction from combining assets.

Core 3: Simple Linear Regression

Regression Model:
Yi = b0 + b1 × Xi + εi

Where:
b0 = intercept (y-intercept)
b1 = slope = Cov(X,Y) / Var(X)
εi = error term

Coefficient of Determination (R²):
R² = SSR / SST = variation explained by regression / total variation
Range: 0 ≤ R² ≤ 1 (closer to 1 = better fit)

Standard Error of the Estimate (SEE):
SEE = √[SSE / (n - 2)]

Hypothesis test: t-statistic = (b1 - 0) / SEE(b1). If |t| > critical t-value, b1 is statistically significant.

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Subject 3: Financial Statement Analysis (FSA)

Weight and Importance

• Exam weight: 11–14% (one of the highest-weighted topics at Level I)
• Prerequisite: Candidates without accounting background often find this topic challenging
• Level II connection: Core to equity valuation and credit analysis

The Five Financial Statements

Statement	Content	Timeframe
Balance Sheet	Assets, liabilities, equity	Point in time
Income Statement	Revenue, expenses, profit	Period
Cash Flow Statement	Cash inflows and outflows	Period
Statement of Changes in Equity	Changes in shareholders’ equity	Period
Notes (Footnotes)	Detailed disclosures	—

IFRS vs US GAAP Key Differences

Item	IFRS	US GAAP
Inventory valuation	FIFO, weighted average only (LIFO prohibited)	FIFO, LIFO, weighted average all allowed
Development costs	Can be capitalized if criteria met	Generally expensed immediately
Revaluation model	Allowed for PP&E	Cost model only
Lease classification	Single model (IFRS 16)	Finance vs operating lease distinction
Revenue recognition	IFRS 15 (5-step model)	ASC 606 (similar 5-step)

Key Financial Ratio Analysis

Profitability ratios:

Gross Margin         = Gross Profit / Revenue
Operating Margin     = Operating Income / Revenue
Net Profit Margin    = Net Income / Revenue
ROE                  = Net Income / Average Equity
ROA                  = Net Income / Average Total Assets

Liquidity ratios:

Current Ratio   = Current Assets / Current Liabilities
Quick Ratio     = (Current Assets - Inventory) / Current Liabilities
Cash Ratio      = Cash and Equivalents / Current Liabilities

Leverage ratios:

Debt-to-Equity      = Total Debt / Shareholders' Equity
Interest Coverage   = EBIT / Interest Expense

DuPont Analysis

ROE = Net Profit Margin × Asset Turnover × Financial Leverage
    = (Net Income/Revenue) × (Revenue/Total Assets) × (Total Assets/Equity)

Three-factor decomposition:
- Net Profit Margin:  cost efficiency
- Asset Turnover:     asset utilization efficiency
- Financial Leverage: degree of debt usage

Five-factor extended:
ROE = Tax Burden × Interest Burden × EBIT Margin × Asset Turnover × Leverage

Cash Flow Statement Analysis

Three activities:

1. Operating (CFO): cash generated from core business
   Indirect method: Net Income + non-cash adjustments + working capital changes

2. Investing (CFI): capital expenditures and financial asset transactions
   - Equipment purchase: outflow (investment)
   - Equipment sale: inflow

3. Financing (CFF): capital raising and repayment
   - Stock issuance: inflow / Dividends paid: outflow
   - Borrowing: inflow / Repayment: outflow

Healthy company cash flow pattern: CFO (+) / CFI (−) / CFF (±)

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Key Formula Summary

Compound FV:       FV = PV × (1 + r)^n
Holding Period:    HPR = (P1 - P0 + D) / P0
Arithmetic Mean:   AM = Σ Ri / n
Geometric Mean:    GM = [(1+R1)(1+R2)...(1+Rn)]^(1/n) - 1
Coefficient of Variation: CV = σ / E(R)  [lower is more efficient]
Sharpe Ratio:      Sharpe = (Rp - Rf) / σp
ROE (DuPont):      ROE = Net Margin × Asset Turnover × Leverage

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Key Concept Cards

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Practice Questions

Q1. An analyst hears from a corporate executive that next quarter’s earnings will significantly miss market estimates. The analyst wants to short the company’s stock. Which standard does this violate?

This violates Standard II(A) — Material Nonpublic Information. The earnings data is material (it would affect reasonable investors’ decisions) and nonpublic (not yet disclosed). The analyst must immediately cease any trading or recommendations based on this information and report it to the compliance department.

Q2. Two companies, A and B, both report 15% ROE. Company A’s ROE stems from a high net profit margin; Company B’s from high financial leverage. How should an investor evaluate the difference?

Using DuPont analysis (ROE = Net Margin × Asset Turnover × Financial Leverage), Company A’s 15% comes from genuine earnings power and is more sustainable. Company B’s 15% is driven by debt leverage, which makes its ROE vulnerable to rising interest rates or economic downturns and increases insolvency risk. Identical ROE figures can have very different quality profiles — always analyze the source.

Q3. If a company applies LIFO instead of FIFO in a rising-price environment, what impact does this have on its financial statements?

Applying LIFO in a rising-price environment: ① recently purchased (higher-cost) inventory is recognized first as COGS, increasing COGS → lower operating and net income. ② The balance sheet shows older (lower-cost) inventory, understating actual market value. ③ Lower taxable income → tax savings. However, IFRS-reporting companies cannot use LIFO, so this strategy is unavailable to them.