Reading 26: Evaluating Financial Reporting Quality LOSf～

problems, accounts, reporting, following, statements

LOS f: Identify and explain problems in financial reporting related to revenue recognition, expense recognition, the reporting of assets and liabilities, and the cash flow statement.

Q1. Which of the following statements about cash flow are correct or incorrect?

Statement #1: The cash effects of decreasing accounts payable turnover are unlimited.

Statement #2: The tax benefits from employee stock options can result in a significant source of investing cash flow.

Statement #1 Statement #2

A) Incorrect Incorrect

B) Correct Incorrect

C) Incorrect Correct

Q2. Charger Corporation offers extended payment terms to its customers. In order to finance its accounts receivable, Charger is

considering two alternatives. The first alternative is to borrow against the receivables. The second alternative is to securitize the

receivables through a special purpose entity. Which alternative would result in lower operating cash flow and lower financing

cash flow?

Lower operating cash flow Lower financing cash flow

A) Securitize Securitize

B) Borrow Securitize

C) Securitize Borrow

Q3. Robin Page, CFA, is a portfolio manager for a medium-sized investment advisory firm that caters to high net worth individuals.

Recent talk among industry insiders speculates that Best Made Industries, a large textile manufacturer, is in financial difficulty

and has possibly been manipulating its financial statements over the past several years to suppress the bad news. Page is

concerned because several of his clients currently have substantial positions in Best Made, and he wants to be sure that he can

provide detailed analysis to them in order to decide whether to take action or not.

The research department of Page’s firm provides basic analysis of the financial statements of all relevant holdings, as well as economic forecasting. As with all holdings in the portfolios under his management, Page has regularly monitored the financial health of the company. Because of the recent rumors surrounding Best Made, Page decides his next course of action should be to thoroughly examine all footnotes to the financial statements as well as the accompanying management discussion and analysis section. He will search for any accounting irregularities as well as any nonoperating or nonrecurring transactions that should be removed for analytical purposes.

In the footnotes to the financial statements, Page reads that a portion of the company’s top managers’ compensation is options that are granted annually through a stock option plan. In the cash flow statement, Page notes that for the past several years, the company repurchased its shares as the options were exercised by its managers. At year end, 15,000 options with a strike price of $10.50 per share were exercised, and the price of the repurchased shares was $12.00 per share. Page is aware that the practice of repurchasing shares to compensate for the dilutive effects of stock option compensation can result in the company issuing financial statements that are in compliance with U.S. GAAP, but in reality may misrepresent the true economics of the transaction.

Page also will compare several years’ worth of Best Made’s financial statements to identify any warning signs that might signal accounting fraud or irregularities. He is aware of techniques used in the past by other large companies that were misleading to those outside the companies. Page will scrutinize the company’s financials, searching for any anomalies or unusual patterns that may indicate earnings manipulation by Best Made.

Page knows that publicly traded companies are under increasing pressures from analysts, creditors, and shareholders to consistently meet or exceed earnings expectations. Firms can exploit GAAP standards and issue financial statements that are simultaneously in technical compliance with reporting standards but misleading to those outside the company. Page is familiar with SAS No. 99, issued by the American Institute of Certified Public Accountants (AICPA), which addresses the topic of “Consideration of Fraud in a Financial Statement Audit.” Page plans on applying the three conditions outlined in the statement to the situation at Best Made to determine if indeed the company’s management has attempted to mislead the public.

There are many ways a company can manipulate their reported operating cash flows in order to deceive outside interested parties such as investors and creditors. Which of the following methods can a company utilize to increase its reported earnings? A firm can:

A) capture a tax benefit when nonqualified stock options are exercised.

B) securitize its accounts receivable.

C) delay payments on its accounts receivables.

Q4. With regards to the repurchase of shares in the market related to the exercise of employee stock options, which of the following

most accurately reflects the economics of the transaction?

Operating Activities Financing Activities

A) $0 $22,500 outflow

B) $0 $180,000 inflow

C) $22,500 outflow $0

Q5. Page is looking for any possible indication of fraud in Best Made’s financial statements. Which of the following is considered to

be the most common earnings manipulation technique used by companies?

A) Recognizing revenue too soon.