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.

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) increase its operating margins relative to industry peers.

C) improve its leverage ratios and reduce its perceived leverage.

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.

In measuring earnings quality, which of the following statements is most appropriate?

A) Accruals can be measured as the change in net operating assets (NOA) over a period of time.

B) The higher the accruals ratio, the higher the earnings quality.

C) Accruals can be measured as net income less cash flows from operations (CFO) less cash flows from financing (CFF).

Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most indicative of a higher quality of earnings when attempting to forecast future earnings?

A) Higher degree of conservatism of earnings.

B) Higher degree of persistence of earnings.

C) Higher level of earnings.

Costiuk Inc. (Costiuk) saw a large increase in its net operating assets (NOA) over the year. During the year, it also reported a number of nonoperating revenues and deferred revenues. Which of the following statements regarding Costiuk’s increase in NOA and the most likely item to self-correct is most accurate?

Increase in NOA

Most likely item to self-correct

A) suggests lower earning quality nonoperating revenues

B) suggests higher earning quality nonoperating revenues

C) suggests lower earning quality deferred revenues

Nolan Corporation (Nolan) is a successful and publicly-traded U.S. company that has operated for many years. It manufactures various sporting goods and in recent years, established three subsidiary companies, Soccer Inc. (Soccer), Hockey Inc. (Hockey), and Lacrosse Inc. (Lacrosse). Soccer and Hockey are located in the U.S. and Lacrosse is located in Canada.

Given that its stock is widely followed by analysts, Nolan regularly communicates its earnings expectations to the market.

Nolan’s most recent financial statements are provided in Exhibit 1.

Balance Sheet As of December 31 (in thousands)
	2008	2007
Assets
Cash	$1,230	$1,805
Accounts receivable	4,900	4,610
Inventory	7,240	4,830
Fixed assets, net	18,300	16,500
Total assets	$31,670	$27,745
Liabilities and Equity
Accounts payable	$1,860	$1,200
Current portion of long-term debt	3,306	3,095
Long-term debt	22,000	20,000
Total liabilities	$27,166	$24,295
Common stock	2,000	2,000
Retained earnings	2,504	1,450
Total Liabilities and Equity	$31,670	$27,745

Income Statement Year Ended December 31, 2008 (in thousands)
Sales	$21,500
Cost of goods sold	(13,620)
Depreciation expense	(2,100)
SG&A expense	(1,750)
Interest expense	(1,420)
Taxes	(910)
Net income	$1,700

Cash flow Statement Year Ended December 31, 2008 (in thousands)
Cash from operations	$1,760
Cash from investing	(3,900)
Cash from financing	1,565
Change in cash	$(575)

Nolan has calculated accrual ratios for its subsidiaries, Soccer and Hockey, in Exhibit 2.

Exhibit 2: Accrual ratios for Soccer and Hockey

Accrual Ratio	2008	2007
Soccer Inc.	13.5%	11.4%
Hockey Inc.	10.7%	11.2%

To protect itself from a multitude of business and financial risks, Nolan uses derivatives to manage its risks. It has engaged in several different hedges during the year, including a net investment hedge of a foreign subsidiary, a cash flow hedge, and a fair value hedge.

Which of the following statements best describes the term forecast error?

A) The difference in a firm’s reported earnings and the consensus buy-side earnings forecast.

B) The difference in a firm’s reported earnings and the firm’s internal earnings forecast communicated to the market.

C) The difference in a firm’s reported earnings and the consensus sell-side earnings forecast.

A) 15.5%.

B) 14.4%.

C) 16.6%.

A) 16.0%.

B) -1.8%.

C) 9.5%.

A) Hockey’s earnings quality is lower than Soccer’s and its earnings quality is deteriorating compared to Soccer’s.

B) Hockey’s earnings quality is higher than Soccer’s but its earnings quality is deteriorating compared to Soccer’s.

C) Hockey’s earnings quality is higher than Soccer’s and its earnings quality is improving compared to Soccer’s.

A) Net income and income from continuing operations.

B) EBIT and income from continuing operations.

C) EBITDA and income from continuing operations.

A) Unrealized gains and losses from the derivative bypass the income statement and are reported in shareholders’ equity as part of other comprehensive income.

B) Only realized gains and losses from the derivative are recognized in the income statement.

C) Unrealized gains and losses from the derivative are recognized in the income statement.