Financial Reporting and Analysis 【Reading 33】Sample 2012, suspects, following

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Joan Zeller, CFA, suspects Cornwall Carpets is overstating its profits. Which of the following is least likely to motivate Cornwall to overreport?

A) Cornwall is attempting to get lawmakers to institute a tariff.

B) Cornwall depends heavily on stock options to compensate its employees.

C) Cornwall’s debt covenants are strict.

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The satisfaction of debt covenants and profit estimates are strong incentives to overstate earnings. Since stock prices tend to follow earnings over time, the use of stock for compensation could drive executives to inflate profit numbers. However, a company attempting to get trade relief is more likely to underreport earnings.

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Which of the follow characteristics is the least compelling evidence that a company has a conservative financial-reporting strategy?

A) Fixed assets are carried at book value.

B) The LIFO method is used.

C) Earnings growth has been steady and dependable over the last few years.

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Steady earnings growth can be a sign of manipulation of the numbers. It is not a sure sign, but of the choices, the earnings growth is the only one that presents a yellow flag with regard to earnings quality. The LIFO method is considered more conservative for the income statement than FIFO; FIFO is preferred on the balance sheet statement – neither is exclusively more conservative. Most fixed assets are carried at book value – that fact alone says nothing about a company’s financial reporting.

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Samson Therapeutics records all leases as operating leases. The company most likely wanted to reduce:

A) leverage.

B) expenses.

C) inventory.

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Finance (capital) leases are recorded on the balance sheet, and by recording all leases as operating leases, the company can reduce its leverage. Lease accounting has no effect on inventory. "Expenses" is not the best answer as operating leases will result in higher expenses in the later years relative to the finance (capital) lease.

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Glenmark Blades and Propellers has set up special purpose entities to handle its manufacturing. The company does not consolidate those entities. Glenmark is most likely obeying:

A) neither the spirit of the law nor the letter of the law.

B) the spirit of the law but not the letter of the law.

C) the letter of the law but not the spirit of the law.

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Rules regarding special purpose entities (SPE) are quite broad, leaving companies with substantial leeway in interpretation. Separating capital-intensive manufacturing operations from the parent company’s books could give Glenmark a more appealing debt or asset picture. While companies can often opt not to consolidate SPEs, the goal of such entities is not to allow a company to manipulate its financial ratios.

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Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage value of its equipment. This would:

A) overstate liabilities.

B) overstate earnings.

C) understate earnings.

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Overstating the salvage value reduces depreciation expense, which in turn increases earnings.

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Analyst Jane Kilgore is worried that some of Maxwell Research’s accrual accounting practices will lead to excessive operating earnings recognition in the near-term. Examples of Kilgore's concerns include the following:

• Accelerated revenue recognition of service agreements.
• Classification of recurring revenue as nonrecurring revenue.
• Understated inventory obsolescence.

Which of Kilgore’s concerns is least likely to overstate current operating earnings?

A) Accelerated revenue recognition of service agreements.

B) Understated inventory obsolescence.

C) Classification of recurring revenue as nonrecurring revenue.

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Classification of recurring revenue as nonrecurring revenue will understate current operating earnings. The other two items act to overstate revenue and understate expenses.

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Which of the following sets of conditions make up the fraud triangle?

A) Pressure, greed, weakness in internal controls.

B) Incentive, opportunity, rationalization.

C) Opportunity, attitude, greed.

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The fraud triangle has three points: incentive/pressure, opportunity, and attitude/rationalization.

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Marnie Colston, CFA, suspects one of the companies she covers is committing accounting fraud. She has uncovered evidence of pressure to increase earnings and weak internal controls. To satisfy the third point of the fraud triangle, Colston should try to find a sign of:

A) motivation.

B) temptation.

C) rationalization.

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The fraud triangle has three points: incentive/pressure, opportunity, and attitude/rationalization

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The fraud triangle consists of three:

A) conditions usually present when fraud occurs.

B) strategies for unearthing financial fraud.

C) of the of the most common types of fraud.

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The fraud triangle is a creation of the American Institute of Certified Public Accountants and represents three conditions usually present when fraud occurs.

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Jane Kilgore, a stock analyst, is concerned about Maxwell Research’s organizational structure. To investigate the stability of that structure, Kilgore would be best served by looking at:

A) the amount of judgment calls used in company accounting.

B) management turnover.

C) accounting-department turnover.

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All of the factors listed above are of concern to an analyst looking at the possibility of fraudulent accounting. But to assess the stability of the organizational structure, the best option is a look at management turnover. High turnover rates in the accounting department may be indicative of deficient internal controls, but are too localized to be a true indicator of organizational stability. Excessive judgment calls in accounting are worrisome, but is not likely to be a direct reflection of an unstable organizational structure, as much as poor operational policies.