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LOS c: List and explain the opportunities and motivations for management to intervene in the external financial reporting process, and the mechanisms that discipline such intervention. fficeffice" />

Q1. 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.

Correct answer is C)

The LIFO method is considered a more conservative strategy for inventory accounting than FIFO. Most fixed assets are carried at book value – that fact alone says nothing about a company’s financial reporting. But 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 regards to earnings quality.

 

Q2. Joan Zeller, CFA, suspects Cornwall Carpets is overstating its profits. Which of the following is least likely to motivate ffice:smarttags" />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.

Correct answer is C)

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.

 

Q3. Stinson Motors is attempting to make itself look more profitable. To accomplish this, the company is most likely to:

A)   understate assets.

B)   overstate equity.

C)   overstate sales.

Correct answer is A)

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.

 

Q4. 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.

Correct answer is A)

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.

 

Q5. 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)   Risk of bankruptcy.

C)   Certification by senior management.

Correct answer is B)

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.