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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.

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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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Complete the following sentence. The cash component of income is ___________ than the accrual component.

A) more persistent.

B) less persistent.

C) the same persistence.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.