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Financial Reporting and Analysis【 Reading 26】Sample

Consider the following statements:

Statement 1:

Compared to the cash basis of accounting, the accrual basis of accounting provides more timely information about future cash flows.

Statement 2:

Compared to the cash basis of accounting, the accrual basis requires more use of discretion than the cash basis.

Are these statements CORRECT?
A)
Yes.
B)
No, because it is actually the cash basis of accounting that provides more timely and relevant information to users about future cash flows.
C)
No, because it is actually the cash basis of accounting that results in more difficulty in properly assigning revenues and expenses to the appropriate periods.



Users of financial information seek timely information about future cash flows. The accrual basis of accounting provides this information at the earliest appearance of objective evidence. Thus, accrual accounting provides more timely and relevant information to users. The cash basis is more concerned with recording cash flows for transactions that have already occurred.Accrual accounting (not cash-based accounting) necessitates the use of discretion because of the many estimates and judgments involved with assigning revenue and expense to the appropriate periods.

Consider the following statements:

Statement 1:

Compared to the cash basis of accounting, the accrual basis of accounting provides more timely information about future cash flows.

Statement 2:

Compared to the cash basis of accounting, the accrual basis requires more use of discretion than the cash basis.

Are these statements CORRECT?
A)
Yes.
B)
No, because it is actually the cash basis of accounting that provides more timely and relevant information to users about future cash flows.
C)
No, because it is actually the cash basis of accounting that results in more difficulty in properly assigning revenues and expenses to the appropriate periods.



Users of financial information seek timely information about future cash flows. The accrual basis of accounting provides this information at the earliest appearance of objective evidence. Thus, accrual accounting provides more timely and relevant information to users. The cash basis is more concerned with recording cash flows for transactions that have already occurred.Accrual accounting (not cash-based accounting) necessitates the use of discretion because of the many estimates and judgments involved with assigning revenue and expense to the appropriate periods.

TOP

A manufacturing firm purchases equipment for use in its operations. With regard to recording the purchase using the cash basis versus the accrual basis of accounting, which of the following statements is most appropriate?
A)
With the cash basis, revenues and expenses relating to the equipment are generally recognized in the same period.
B)
With the accrual basis, the cost of the equipment is allocated to the cash flow statements over the asset’s life.
C)
With the cash basis, revenues and expenses relating to the equipment are generally recognized in different periods.



With the cash basis of accounting, revenues are recognized when cash is collected and expenses are recognized when cash is paid. Therefore, the cash flows may occur in different periods than when the revenues are actually earned or when the expenses are actually incurred. For example, the purchase of equipment used in a firm’s manufacturing operation may result in an immediate cash outflow but the equipment generates revenues over its useful life. In this case, the revenues and expense are reported in different periods.
With the accrual basis of accounting, revenues are recognized when earned and expenses are recognized when incurred, regardless of the timing of the cash flows. With the equipment purchase, the cost of the equipment will be allocated to the income statement (not cash flow statement) over the asset’s life and at the same time, matched with the revenues generated.

TOP

Complete the following sentence. An analyst would apply _________ to the cash component of income compared to the accrual component when evaluating company performance.
A)
a higher weighting.
B)
a lower weighting.
C)
the same weighting.



Since the cash component has more sustainability in the future than the accrual component, an analyst would apply a higher weighting to the cash component of income than the accrual component when evaluating company performance.

TOP

Holding everything else constant, the existence of which of the following items will most likely result in direct cash inflows or outflows for a firm in the future?
A)
Unearned revenue.
B)
Accrued expenses.
C)
Deferred expenses.



Accrued expenses are expenses that have been incurred but not yet paid. For example, a firm may recognize wage expense in one period but actually pay the wages in a later period. In this case, when the expense is recognized in the income statement, a liability is increased on the balance sheet (i.e., wages payable). When the wages are paid, the liabilities decrease as does the firm’s cash (cash outflow occurs in the future).Unearned (deferred) revenue occurs when payment is received in advance of providing goods or services. Unearned revenue is reported as a liability on the balance sheet. Once the revenue is earned, the liability decreases. For example, a magazine subscription is usually paid in advance. When received, the publisher increases its cash and records a liability for its obligation to deliver (cash inflow occurs now). Once delivery occurs, revenue is recognized and the liability decreases.
Deferred expenses are costs that will benefit future periods. These costs usually involve noncurrent assets and prepaid assets. For example, a tenant must usually pay his rent in advance. The result is a decrease in the tenant’s cash and an increase in a prepaid asset (cash outflow occurs now). Once the rent expires, expense is recognized and the asset decreases.

TOP

Complete the following sentence. The cash component of income is ___________ than the accrual component.
A)
more persistent.
B)
less persistent.
C)
the same persistence.



The accrual component of income (accruals) is less persistent than the cash component. By persistent we mean the income is sustainable; that is, a dollar of earnings today implies a dollar of earnings in future periods. Lower persistency is partially due to the estimates involved with accrual accounting.

TOP

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.



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

TOP

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.



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

TOP

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)
Certification by senior management.
C)
Risk of bankruptcy.



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.

TOP

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.



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)

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.



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)

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 decline in inventory turnover.
C)
a delay in the recognition of expenses.



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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