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Ch 11: Financial Reporting Quality
Terms in this set (16)
The information provided by a low-quality financial report will most likely:
decrease company value.
indicate earnings are not sustainable.
impede the assessment of earnings quality.
C is correct. Financial reporting quality pertains to the quality of the information contained in financial reports. High-quality financial reports provide decision-useful information that faithfully represents the economic reality of the company. Low-quality financial reports impede assessment of earnings quality. Financial reporting quality is distinguishable from earnings quality, which pertains to the earnings and cash generated by the company's actual economic activities and the resulting financial condition. Low quality earnings are not sustainable and decrease company value.
To properly assess a company's past performance, an analyst requires:
high earnings quality.
high financial reporting quality.
both high earnings quality and high financial reporting quality.
B is correct. Financial reporting quality pertains to the quality of the information contained in financial reports. If financial reporting quality is low, the information provided is not useful to assess the company's performance. Financial reporting quality is distinguishable from earnings quality, which pertains to the earnings and cash generated by the company's actual economic activities and the resulting financial condition.
Low quality earnings most likely reflect:
low-quality financial reporting.
company activities which are unsustainable.
information that does not faithfully represent company activities
B is correct. Earnings quality pertains to the earnings and cash generated by the company's actual economic activities and the resulting financial condition. Low-quality earnings are likely not sustainable over time because the company does not expect to generate the same level of earnings in the future or because earnings will not generate sufficient return on investment to sustain the company in the future. Earnings that are not sustainable decrease company value. Earnings quality is distinguishable from financial reporting quality, which pertains to the quality of the information contained in financial reports.
Financial reports of the lowest level of quality reflect:
biased accounting choices.
accounting that is non-compliant with GAAP.
A is correct. Financial reports span a quality continuum from high to low based on decision-usefulness and earnings quality (see Exhibit 2 of the reading). The lowest-quality reports portray fictitious events, which may misrepresent the company's performance and/or obscure fraudulent misappropriation of the company's assets.
If a particular accounting choice is considered aggressive in nature, then the financial performance for the current period would most likely:
exhibit an upward bias.
exhibit a downward bias.
B is correct. Aggressive accounting choices aim to enhance the company's reported performance by inflating the amount of revenues, earnings, and/or operating cash flow reported in the period. Consequently, the financial performance for the current period would most likely exhibit an upward bias.
Which of the following is most likely to reflect conservative accounting choices?
Decreased reported earnings in later periods
Increased reported earnings in the current period
Increased debt reported on the balance sheet at the end of the current period
C is correct. Accounting choices are considered conservative if they decrease the company's reported performance and financial position in the current period. Conservative choices may increase the amount of debt reported on the balance sheet. Conservative accounting choices may decrease the amount of revenues, earnings, and/or operating cash flow reported in the current period and increase those amounts in later periods.
Which of the following statements most likely describes a situation that would motivate a manager to issue low-quality financial reports?
The manager's compensation is tied to stock price performance.
The manager has increased the market share of products significantly.
The manager has brought the company's profitability to a level higher than competitors.
A is correct. Managers often have incentives to meet or beat market expectations, particularly if management compensation is linked to increases in stock prices or to reported earnings.
A company is experiencing a period of strong financial performance. In order to increase the likelihood of exceeding analysts' earnings forecasts in the next reporting period, the company would most likely undertake accounting choices that:
inflate reported revenue in the current period.
delay expense recognition in the current period.
accelerate expense recognition in the current period.
C is correct. In a period of strong financial performance, managers may pursue accounting choices that increase the probability of exceeding next period's earnings forecasts. By accelerating expense recognition or delaying revenue recognition, managers may increase earnings in the next period and increase the likelihood of exceeding next period's earnings targets.
Which of the following situations will most likely motivate managers to inflate earnings in the current period?
Possibility of bond covenant violation
Earnings in excess of analysts' forecasts
Earnings that are greater than the previous year
A is correct. The possibility of bond covenant violations may motivate managers to inflate earnings in the current period. By inflating earnings in the current period, the company may be able to avoid the consequences associated with violating bond covenants.
Which of the following best describes an opportunity for management to issue low-quality financial reports?
Ineffective board of directors
Pressure to achieve some performance level
Corporate concerns about financing in the future
A is correct. Opportunities to issue low quality financial reports include internal conditions such as an ineffective board of directors and external conditions such as accounting standards that provide scope for divergent choices. Pressure to achieve some performance level and corporate concerns about financing in the future are examples of motivations to issue low-quality financial reports. Typically, three conditions exist when low-quality financial reports are issued: opportunity, motivation, and rationalization.
An audit opinion of a company's financial reports is most likely intended to:
assure that financial information is presented fairly.
C is correct. An audit is intended to provide assurance that the company's financial reports are presented fairly, thus providing discipline regarding financial reporting quality. Regulatory agencies usually require that the financial statements of publicly traded companies be audited by an independent auditor to provide assurance that the financial statements conform to accounting standards. Privately held companies may also choose to obtain audit opinions either voluntarily or because an outside party requires it. An audit is not typically intended to detect fraud. An audit is based on sampling and it is possible that the sample might not reveal misstatements.
If a company uses a non-GAAP financial measure in an SEC filing, then the company must:
give more prominence to the non-GAAP measure if it is used in earnings releases.
provide a reconciliation of the non-GAAP measure and equivalent GAAP measure.
exclude charges requiring cash settlement from any non-GAAP liquidity measures.
B is correct. If a company uses a non-GAAP financial measure in an SEC filing, it is required to provide the most directly comparable GAAP measure with equivalent prominence in the filing. In addition, the company is required to provide a reconciliation between the non-GAAP measure and the equivalent GAAP measure. Similarly, IFRS require that any non-IFRS measures included in financial reports must be defined and their potential relevance explained. The non-IFRS measures must be reconciled with IFRS measures.
A company wishing to increase earnings in the current period may choose to:
decrease the useful life of depreciable assets.
lower estimates of uncollectible accounts receivables.
classify a purchase as an expense rather than a capital expenditure.
B is correct. If a company wants to increase reported earnings, the company's managers may reduce the allowance for uncollected accounts and uncollected accounts expense reported in the period. Decreasing the useful life of depreciable assets would increase depreciation expense and decrease earnings in the current period. Classifying a purchase as an expense rather than a capital expenditure would decrease earnings in the current period. The use of accrual accounting may result in estimates included in financial reports, because all facts associated with events may not be known at the time of recognition. These estimates can be grounded in reality or can be managed by the company to present a desired financial picture.
Bias in revenue recognition would least likely be suspected if:
the firm engages in barter transactions.
reported revenue is higher than the previous quarter.
revenue is recognized before goods are shipped to customers.
B is correct. Bias in revenue recognition can lead to manipulation of information presented in financial reports. Addressing the question as to whether revenue is higher or lower than the previous period is not sufficient to determine if there is bias in revenue recognition. Additional analytical procedures must be performed to provide warning signals of accounting malfeasance. Barter transactions are difficult to value properly and may result in bias in revenue recognition. Policies that make it easier to prematurely recognize revenue, such as revenue being recognized before goods are shipped to customers, may be a warning sign of accounting malfeasance.
Which of the following is an indication that a company may be recognizing revenue prematurely? Relative to its competitors, the company's:
asset turnover is decreasing.
receivables turnover is increasing.
days sales outstanding is increasing.
C is correct. If a company's days sales outstanding (DSO) is increasing relative to competitors, this may be a signal that revenues are being recorded prematurely or are even fictitious. There are numerous analytical procedures that can be performed to provide evidence of manipulation of information in financial reporting. These warning signs are often linked to bias associated with revenue recognition and expense recognition policies.
Which of the following would most likely signal that a company may be using aggressive accrual accounting policies to shift current expenses to later periods? Over the last five-year period, the ratio of cash flow to net income has:
increased each year.
decreased each year.
fluctuated from year to year.
B is correct. If the ratio of cash flow to net income for a company is consistently below 1 or has declined repeatedly over time, this may be a signal of manipulation of information in financial reports through aggressive accrual accounting policies. When net income is consistently higher than cash provided by operations, one possible explanation is that the company may be using aggressive accrual accounting policies to shift current expenses to later periods.
t/f: The purpose of a work sheet is to plan adjustments and summarize the information necessary to prepare financial statements.
The major problem with the goal of shareholder wealth maximization is that it ignores the timing of the expected returns of the firm.
What are amounts owed to employees for salaries and wages at the end of the accounting period and are a current liability? Expected to be paid next pay period.
Capital gains and losses are treated the same as ordinary income for tax purposes.
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