Practice exam Book 1, exam 3, PM, question 69. When i did a timed practice test, i could not get this answer. I guess and moved on. I always believed you had to adjust for LIFO, and Pension liabilities that are not correct on the balance sheet and view them at fair value to arrive at the correct book value. In fact if you read page 302 of the notes it specifically says to adjust for these factors. However on the practice exam the answer key does not adjust for these and uses the book value given without adjustments. My question is when should i be adjusting book values??? Notes say to adjust, practice exam said i was wrong to. Here is the answer they give with no adjustments to book value. "Beginning book value (Bt-1) $32.16 ($4,181,000 / 130,000) Earnings per share forecast (Et) $6.15 (given) Dividend forecast (Dt = Et × payout ratio) $0.31 ($6.15 × 5%) Forecast book value per share (Bt-1 + Et − Dt) $38.00 Equity charge per share (r × Bt-1) $4.12 (0.128 × $32.16) Per share RIt [Et − (r × Bt-1)] $2.03 ($6.15 − $4.12) For Further Reference: Study Session 12, LOS 45.c SchweserNotes: Bk 4 p.295 CFA Program Curriculum: Vol. 4 p.534 "
I have never adjusted the book values for calculating the BV for Residual income. This is an equity problem and I don’t see an item set where you will have you make accounting adjustments. I would say if this were to come up on the exam there would be no adjustments. If there was I’m sure they would indicate to do so.
i just seemed very odd, that the SAME EXACT accounting adjustments the notes say to make, are actually in the practice exam question. However you are not supposed to use that info. makes no sense.
See footnote 12, p 542 of CFAI curriculum Book 4. Remember that the clean surplus relation has to hold for us to use the residual income method, and according to this footnote, there are (the horror! the horror!) “items that bypass the income statement (dirty surplus items)”… section 5 p 553: “To most accurately apply the residual income model in practice, the analyst may have to adjust BV of common equity for off-balance-sheet items and adjust reported net income to obtain comprehensive income…” So if the clean surplus relation does not hold, we can still use residual income if we replace net income by comprehensive income. And relevant to your example, “certain pension adjustments” can be items that need to be considered as they bypass the income statement. However, I think you can just assume that the earnings estimates and so on given take this into account, otherwise if you didn’t have these and actually had to do the calculation, I believe that you would have to make the pension liability difference (fair value - PBO = 787,000 but only 487,000 recorded) and the $78,400 additional charge to equity from the LIFO to FIFO adjustment. HTH