土豆妮

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) Classification of recurring revenue as nonrecurring revenue.

B) Accelerated revenue recognition of service agreements.

C) Understated inventory obsolescence.

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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.

土豆妮

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) management turnover.

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

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.

土豆妮

Based on her analysis of Maxwell Research’s internal operations and business climate, analyst Jane Kilgore is concerned about management’s opportunities to commit fraud. Which of the following characteristics should worry Kilgore least?

A) More than half of Maxwell’s revenue is generated in emerging markets.

B) Maxwell’s market penetration gives it the ability to dictate terms to vendors.

C) More than a third of Maxwell’s total sales go to its own consolidated subsidiaries.

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High levels of related-party transactions are worrisome, particularly when those parties are not audited. But transactions within the company between subsidiaries consolidated in a company’s audited financial statements are neither unusual nor a particularly fertile ground for fraud. Both remaining characteristics are legitimate risk factors.

土豆妮

Frank Brill, CFA, is concerned that Moses Aviation is overstating its profits. The best indicator of such action would be Moses Aviation’s:

A) sales-growth rate of nearly twice the industry average.

B) rising inventory.

C) recognition of revenue from barter transactions.

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While an unusually high sales-growth rate may indicate fraud, it could also indicate good management. It’s a yellow flag, but not the best indicator of accounting shenanigans. Rising inventory is also a dual signal. It could be meant to overstate profits, or it could simply reflect an actual buildup of inventory in response to market forces or corporate operations. However, companies should not recognize revenue from barter transactions. The additional revenue is likely to improperly boost profits.

土豆妮

During Parlex Chemicals’ media day, four executives spoke. Here are excerpts from all four executives speeches.

Calvin Baynard, CEO: “I’ve been a scientist all my life, but I want to assure shareholders that as CEO I am actively involved in both managing operations and setting accounting policy.”
Kristan Lenz, CFO: “I work closely with our auditors to make sure we are always on the same page.”
Melvin Jackson, COO: “In the past I have told you that Parlex would meet aggressive growth targets. I am proud to say that we have met those targets.”
Sally Yu, compliance director: “All of our executives are required to review Parlex’s ethics policy every year.”

Reporter John Bustard, CFA, is concerned that three of the executives are exhibiting attitudes or rationalizations that can lead to accounting fraud. Bustard should be least concerned about:

A) Jackson.

B) Lenz.

C) Yu.

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Working closely with auditors is a good thing. All of the other statements reflect behavior that can lead to fraudulent accounting. Jackson made a commitment to the media that the company would meet targets – that promise could spark a rationalization to falsify numbers to meet the target. Yu said all executives must review Parlex’s ethics policy, but what about everybody else? Most of the employees are not executives, and if the rank and file, including those in the accounting department, are not familiar with the firm’s ethical standards, it could breed ethical problems throughout the organization.

土豆妮

Marcel Schulte is analyzing various retailing firms. Which of the following items is least indicative of a potential problem with revenue recognition and earnings quality?

A) Use of barter transactions.

B) Disproportionate revenues in the last quarter of the calendar year.

C) Implementing a “bill and hold” arrangement.

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Disproportionate revenues in the last quarter may be an indication of aggressive revenue recognition to meet analyst forecasts but it is much more likely if the firm is a non-seasonal one. A retailing firm presumably has a disproportionate amount of sales during the busy Christmas season in the last quarter of the calendar year so this point alone would not be indicative of a potential problem.

In a barter transaction, two parties exchange goods or services. The main issue is whether: (a) a sale transaction has actually occurred in substance; (b) it is not a “sham” transaction; and (c) the transaction amount is overstated.

Bill and hold occurs when the retailer (seller) invoices the customer but does not ship the goods until a later date. Alternatively, the seller may ship the goods to a location other than the customer’s. In either case, the seller may be recognizing revenue prematurely.

土豆妮

Charles Nicholls, chief investment officer of Gertmann Money Management, is reviewing the year-end financial statements of Zartner Canneries. In those statements he sees a sharp increase in inventories well above the sales-growth rate, and an increase in the discount rate for its pension assets. To determine whether or not Zartner Canneries is cooking the books, what should Nicholls do?

A) Calculate Zartner’s turnover ratios and review the footnotes of its competitors.

B) Check Zartner’s cash-flow statement and review its footnotes.

C) Analyze trends in Zartner’s receivables and consider the changing characteristics of its work force.

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To assess the meaning of the inventory increase, look for declines in industry turnover. And if Zartner changes its pension assumptions, Nicholls should see how those new assumptions compare to those found in the footnotes of financial statements from other companies in the same industry.