Reading 40: Financial Reporting Quality: Red Flags and Accou 2011, management, company, center, style

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Session 10: Financial Reporting and Analysis: Applications and International Standards Convergence
Reading 40: Financial Reporting Quality: Red Flags and Accounting Warning Signs

LOS a: Describe incentives that might induce a company's management to overreport or underreport earnings.

 

 

Joan Zeller, CFA, suspects Cornwall Carpets is overstating its profits. Which of the following is least likely to motivate Cornwall to overreport?

A) Cornwall depends heavily on stock options to compensate its employees.

B) Cornwall’s debt covenants are strict.

C) Cornwall is attempting to get lawmakers to institute a tariff.

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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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Which of the follow characteristics is the least compelling evidence that a company has a conservative financial-reporting strategy?

A) Fixed assets are carried at book value.

B) The LIFO method is used.

C) Earnings growth has been steady and dependable over the last few years.

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Steady earnings growth can be a sign of manipulation of the numbers. It is not a sure sign, but of the choices, the earnings growth is the only one that presents a yellow flag with regard to earnings quality. The LIFO method is considered more conservative for the income statement than FIFO; FIFO is preferred on the balance sheet statement – neither is exclusively more conservative. Most fixed assets are carried at book value – that fact alone says nothing about a company’s financial reporting.

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

A) overstate equity.

B) understate assets.

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.