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.

Stinson Motors is attempting to make itself look more profitable. To accomplish this, the company is most likely to:

A) understate assets.

B) overstate equity.

C) overstate sales.

When a firm’s earnings are finally announced, a negative earnings surprise will most likely occur under which of the following situations?

A) Earlier in the fiscal year, analyst forecasts tend to be more pessimistic than what the firm ends up reporting. Later in the year, analyst forecasts tend to be more optimistic than what the firm ends up reporting.

B) Earlier in the fiscal year, analyst forecasts tend to be more optimistic than what the firm ends up reporting. Later in the year, analyst forecasts tend to be more pessimistic than what the firm ends up reporting.

C) Regardless of the timing, analyst forecasts are more pessimistic than what the firm ends up reporting.

In the U.S., which of the following mechanisms is least likely to reduce management’s opportunities to intervene in a firm’s external financial reporting process?

A) Threat of class action litigation.

B) Risk of bankruptcy.

C) Certification by senior management.

Hatfield Industries is a large manufacturing conglomerate based in the United States with annual sales in excess of $300 million. Its shares are traded on the New York Stock Exchange, and have a market capitalization of nearly $750 million. Hatfield is currently under investigation by the Securities and Exchange Commission (SEC) for accounting irregularities and possible legal violations in the presentation of the company’s financial statements. A due diligence team from the SEC has been sent to Hatfield’s corporate headquarters in Philadelphia for a complete audit in order to further assess the situation.

Several unique circumstances at Hatfield are discovered by the SEC due diligence team during the course of the investigation:

• Management has been involved in ongoing negotiations with the local labor union, of which approximately 40% of its full-time labor force are members. Labor officials are seeking increased wages and pension benefits, both of which Hatfield’s management states is not possible at this time due to decreased profitability and a tight cash flow situation. Labor officials have accused Hatfield’s management of manipulating the company’s financial statements in order to have a reason to not grant any concessions during the course of negotiations.
• All new equipment obtained over the past several years has been established on Hatfield’s books as operating leases, although past acquisitions of similar equipment was nearly always classified as capital leases. Financial statements of industry peers indicate that capital leases for this type of equipment are the norm. The SEC wants Hatfield’s management to provide justification for this apparent deviation from “normal” accounting practices.
• Inventory on Hatfield’s books has been steadily increasing for the past few years in comparison to sales growth. Management credits improved operating efficiencies in its production methods that have contributed to boosts in overall production. The SEC is seeking evidence that Hatfield somehow may have manipulated its inventory accounts.

The SEC due diligence team is not necessarily searching for evidence of fraud, but possible manipulation of accounting standards for the purpose of misleading shareholders and other interested parties. Initial review of Hatfield’s financial statements indicates that at a minimum, certain practices have resulted in low quality earnings.

Labor officials believe that the management of Hatfield is attempting to understate its net income in order to avoid making any concessions in the labor negotiations. Which of the following actions by management will most likely result in low quality earnings?

A) Lengthening the life of a depreciable asset in order to lower the depreciation expense.

B) Lowering the discount rate used in the valuation of the company’s pension obligations.

C) The recognition of revenue at the time of delivery rather than when payment is received.

A) reduce its cost of goods sold and increase it profitability.

B) improve its leverage ratios and reduce its perceived leverage.

C) increase its operating margins relative to industry peers.

A) receivables that are growing faster than sales.

B) a delay in the recognition of expenses.

C) a decline in inventory turnover.