Reading 27: Evaluating Financial Reporting Quality-LOS c 习题 management, reporting, discipline, 2011, class

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Session 7: Financial Reporting and Analysis: Earnings Quality Issues and Financial Ratio Analysis
Reading 27: Evaluating Financial Reporting Quality

LOS c: Discuss the opportunities and motivations for management to intervene in the external financial reporting process and the mechanisms that discipline such intervention.

 

 

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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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.

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Certain GAAP rules can be exploited by companies in order to achieve specific goals, while still remaining within the letter of the law. Aggressive assumptions, such as lengthening the depreciable life of an asset, that are utilized to boost earnings results in a lower quality of earnings. (Study Session 7, LOS 26.d)

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Hatfield has begun recording all new equipment leases on its books as operating leases, a change from its consistent past use of capital leases. What is the most likely motivation behind Hatfield’s change in accounting methodology? Hatfield is attempting to:

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.

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Off balance-sheet financing through the use of operating leases is acceptable when used appropriately. However, companies can use them too aggressively in order to reduce their perceived leverage. A comparison among industry peers and their practices may indicate improper use of accounting methods. (Study Session 7, LOS 26.d)

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The SEC due diligence team is searching for the reason behind Hatfield’s inventory build-up relative to its sales growth. One way to identify a deliberate manipulation of financial results by Hatfield is to search for:

A) receivables that are growing faster than sales.

B) a delay in the recognition of expenses.

C) a decline in inventory turnover.

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A warning sign of accounting manipulation is abnormal inventory growth as compared to sales growth. By overstating inventory, the cost of goods sold is lower, leading to higher profitability. (Study Session 7, LOS 26.e)

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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.

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The negative earnings surprise occurs because the analyst earnings forecasts are higher (too optimistic) than what the firm ends up reporting. The opposite situation where the earnings forecasts are lower (too pessimistic) than what the firm ends up reporting would result in a positive earnings surprise.

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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.

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Although the threat of bankruptcy could be a reason to prevent strategic manipulation, it is clearly the most indirect reason of the three choices. Often, the amount of manipulation is small (i.e. minor adjustments to allow for the reporting of small profits rather than small losses) and would not be perceived to cause a significant market valuation adjustment.

In the U.S., the CEO and CFO must certify the financial statements, which increases their personal risk.

The threat of lawsuits serves as a deterrent to manipulating results.

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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.

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Understating assets could make the return on asset ratio, a measure of profitability, look more attractive. Overstating sales or equity would make profit margins and ROE look lower, or less attractive.