Deck 7: Earnings Management and the Quality of Financial Reporting

Question 1

Which of the following earnings management techniques are NOT presented in Lucent Technologies, Inc.'s case?

A)Shifting Current Revenue to a later period
B)Boosting income with one-time gains
C)Recording revenue too soon or of questionable quality
D)Shifting current expenses to a later or earlier period

Answer 1

A

Question 2

The SEC Advisory Committee on Improvements in Financial Reporting identified each of the following as a view of equity and credit analysts about investor's views on materiality and financial statement restatements except for:

A)Bright line rules are useful in making materiality judgments.
B)Bright line rules are not really useful in making materiality judgments.
C)The disclosure provided on restatements is not adequate.
D)One of the major costs of restatements is the amount of time between the restatement announcement and the final resolution of the restatement.

Answer 2

A

Question 3

Which of the following author(s) define(s) earnings management as "reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results."?

A)Dechow and Skinner
B)Healy and Wahlen
C)Schipper
D)Thomas
E)McKee

Answer 3

D

Question 4

Which of the following author(s) emphasize(s) a "purposeful act by management in pursuit of its own self-interests as might be the case when earnings are manipulated to get the stock price up in advance of the exercise of stock options."?

A)Dechow and Skinner
B)Healy and Wahlen
C)Schipper
D)Thomas
E)McKee

Question 5

Which of the following is NOT a motivation to manage earnings?

A)Companies try to meet or beat Wall Street earnings projections in order to grow market capitalization and increase the value of stock options.
B)The ideal pattern of earnings is volatility each year over a period of time.
C)To smooth net income over time.
D)To maximize compensation including bonuses.

Question 6

Which of the following authors(s) focus(es) on "management's intent to deceive the stakeholders by using accounting devices to positively influence reported earnings."?

A)Dechow and Skinner
B)Healy and Wahlen
C)Schipper
D)Thomas
E)McKee

Question 7

Each of the following techniques was used by Gemstar TV Guide International in its accounting fraud:

A)Created cookie jar reserves of advertising revenue to smooth net income.
B)Engaged in round trip transactions whereby Gemstar paid money to a third party to advertise its services and capitalized that cost while the third party used Gemstar's funds to buy advertising from Gemstar, and the company recorded 100% of that amount as revenue while capitalizing the cost of its advertising payments.
C)Recorded revenue under expired, disputed, or non-existent agreements, and properly reported this as licensing and advertising revenue.
D)Inflated advertising revenue by improperly recording and reporting revenue amounts from multiple-elements transactions.

Question 8

Which of the following is NOT considered "earnings management"?

A)"Earnings management" is to project smoother earnings from year to year.
B)Managements emphasis on achieving long-term results to meet their financial goals.
C)A common practice of "earnings management" is to use "cookie-jar reserves."
D)The executives manipulate the earnings in order to match their predetermined target.

Question 9

Which of the following authors(s) contend(s) "earnings management can be acceptable if linked to the choice of alternative accounting principles and estimates that report higher earnings than other methods might report given the circumstances.Only outright fraud is an unacceptable earnings management action."?

A)Dechow and Skinner
B)Healy and Wahlen
C)Schipper
D)Thomas
E)McKee

Question 10

Which of the following is NOT mentioned in the Xerox's case?

A)Xerox misled investors by polishing its reputation on Wall Street and to boost the company's stock price.
B)The ethical tone at the top set by CEOs Allaire and Thomas, and CFO Romeril, which equated business success with meeting long-term earnings target.
C)Xerox failed to disclose GAAP violations that led to acceleration in the recognition of approximately $3 billion in equipment revenues.
D)Xerox recognized a greater amount of revenue on leases in early years than warranted and didn't break out revenues that should have been deferred and recognized in future years.

Question 11

In the Glass Lewis survey of financial statements, a somewhat surprising possible cause of the decline in restatements in 2008 may have been due to:

A)Internal control requirements under generally accepted auditing standards
B)Identifying materiality amounts based on both quantitative and qualitative factors
C)More ethical management
D)Relaxation of materiality standards by the SEC

Question 12

The best definition of a financial restatement is:

A)A company, either voluntarily or under prompting by its auditors or regulators, revises its public financial information that was previously reported
B)A company, either voluntarily or under prompting by its auditors or regulators, revises its public financial information for the current period
C)An adjustment of financial information due to an error correction
D)All are part of the definition

Question 13

If a company is managing its earnings, which of the ethical theories are they most likely following?

A)Rights
B)Fairness
C)Egoism
D)Virtue

Question 14

Vorhies identifies four perspectives to help CPAs identify key internal control exceptions under the Sarbanes Oxley Act including:

A)An internal control deficiency caused by accounting manipulations
B)A large variance in an accounting estimate compared with the actual determined amount
C)A misstatement that changes a loss into income or vice versa
D)All were identified

Question 15

Which of the following is NOT an earnings management technique?

A)Failing to write down or write off impaired assets.
B)Releasing questionable reserves into income.
C)Failing to record expenses and related liabilities when future obligations remain.
D)Creating an allowance for uncollectible accounts and adjusting it at year end.

Question 16

From which perspective might one be able to rationalize the ethics of earnings management?

A)From a virtue perspective
B)From a utilitarian perspective
C)From a rights perspective
D)From an ethical perspective

Question 17

SAS No.107 identifies the following aspects of disclosure amounts deemed to be material except for:

A)Disclosing an item in one year but not in the next year
B)Qualitative aspects of the disclosure
C)Quantitative significance of the disclosure
D)Professional judgment

Question 18

Which technique was used by both WorldCom and Waste Management to manage earnings?

A)Manipulating asset net valuation amounts to minimize operating expenses for a period
B)Accelerating the recording of revenue into an earlier period
C)Delaying needed repairs to a later period
D)All of the above were used

Question 19

In surveys of managers, which technique to manage earnings was considered most acceptable?

A)Changing inventory valuation in order to influence earnings
B)Accounting manipulation
C)Manipulating operating decisions
D)Establishing cookie jar reserves

Question 20

Which of the following is NOT a qualitative factor when assessing materiality?

A)A misstatement that changes a loss into income or vice versa
B)The existence of statutory or regulator reporting requirements that affect materiality thresholds
C)The potential effect of the misstatement on trends, especially trends in profitability
D)The use of simplistic numerical thresholds and rules of thumb

Question 21

The basic ethical principle violated by Andy Fastow in his role as Enron's CFO and involvement with SPEs was:

A)He lied to top management about what he was doing for the SPEs
B)He failed to exercise due care in setting up SPEs
C)He had a conflict of interests in his dual roles
D)All of the above

Question 22

The best way to characterize the role of Sherron Watkins in the downfall of Enron is:

A)She directed the internal auditors to examine numerous transactions that led to the discovery of the fraud
B)She gave in to the pressure of Andy Fastow to go along with materially misstated financial statements
C)She was sent to jail even though she cooperated with the government in its case against Enron
D)She tried to alert Ken Lay about the accounting scandal at Enron

Question 23

Congress passed the "Sarbanes-Oxley Act" on July 30, 2002.Which of the following is NOT true?

A)All reporting companies are required to include in their annual reports a report of management on the company's internal control over financial reporting.
B)New audit standards include a prohibition against independent auditors providing many non-audit services and mandatory audit partner rotation.
C)Only U.S.companies are subject to the disclosure requirements of the Act.
D)The presentation of pro forma information is now required.

Question 24

What is the original motivation by FASB on SPEs?

A)To establish a mechanism to encourage companies to invest in needed assets while keeping related debt of its books.
B)To keep the large amount of debt off the books.
C)To sell non-producing assets to the SPE.
D)To select which assets to sell to the SPEs affecting the gain.

Question 25

"Cookie jar reserves" can best be described as:

A)Buying a lot of chocolate chip cookies, storing them for when you have a hunger attack, and then releasing them into your stomach.
B)Overstating or understating allowances and reversing amounts in the future to smooth out net income over time.
C)Accelerating the recording of revenues into an earlier year than is warranted.
D)Delaying the recording of expenses to a later year to boost income in the current year.

Question 26

What is the culture at Enron that is discussed in the case?

A)Employees worked later and later.
B)Employees were evaluated in groups; the goal was to remove the bottom 20% of each group every year.
C)Enron had a cutthroat system and encouraged a "yes" culture.
D)All of the above.

Question 27

Which of the following partnership that Enron created eventually lead Enron to an end?

A)JEDI
B)Cactus
C)Chewco
D)Ironman

Question 28

The expression, "Too many corporate managers, auditors, and analysts are participants in a game of nods and winks" is attributable to:

A)Barry Minkow
B)Jerry Seinfeld
C)Bernie Ebbers
D)Arthur Levitt

Question 29

All of the following are examples of "Boosting Income with One-Time Gains" except for:

A)Recording sales that lack economic substance.
B)Boosting profits by selling undervalued assets.
C)Including investment income or gains as part of revenue.
D)Including investment income or gains as a reduction in operating expenses.

Question 30

Xerox leases met the criteria under SFAS No.13 to be accounted for as "sales-type" lease.What did Xerox's top management do that violated GAAP?

A)Xerox recognized the fair value of the equipment leased as income in the period the lease is delivered, less any residual value the equipment is expected to retain once the lease expires.
B)Xerox prorated the portion of the lease payments that represents the fee for repair services and copier supplies over the term of lease against the financing income.
C)Xerox recognized financing revenue when it is earned over the life of the lease.
D)Xerox used the "ROE" method which pulled forward a porting of finance income and recognized it immediately as equipment revenue and the "margin normalization" method which pulled forward a portion of service income and recognized it immediately as equipment revenue.

Question 31

All of the following are examples of "Recording revenue too soon or of questionable quality" except for:

A)Recording sales that lack economic substance.
B)Recording revenue when future services remain to be provided.
C)Recording revenue before shipment or before the customer's unconditional acceptance.
D)Recording revenue even though the customer is not obligated to pay.

Question 32

Which of the following earnings management techniques are NOT presented in Lucent Technologies, Inc.'s case?

A)Shifting Current Revenue to a later period
B)Boosting income with one-time gains
C)Recording revenue too soon or of questionable quality
D)Shifting current expenses to a later or earlier period

Question 33

Which of the following is NOT addressed in the Waste Management's case?

A)The misstatements represented 10% of pre-tax income, which was not considered material.
B)The company employed aggressive accounting practices to enhance its earnings.
C)The company used the gain to offset unrelated operating expenses which was not in conformity with GAAP.
D)The company's auditor, Arthur Andersen, had engaged in improper professional conduct.

Question 34

In the Xerox case, who was Xerox's auditor?

A)Ernst & Young
B)Deloitte & Touche
C)Arthur Andersen
D)KPMG

Question 35

Which of the statement regarding PCAOB is NOT true?

A)PCAOB stands for Public Company Accounting Oversight Board.
B)PCAOB assumes the peer review function over registered CPA firms.
C)PCAOB was established before the accounting scandal of Enron.
D)PCAOB protects the public interest by oversight of independent audits.

Question 36

Which of the following is NOT an aggressive accounting practice?

A)Non-GAAP method of capitalization interest on landfill development costs.
B)Failure to properly accrue for tax and self-insurance expense.
C)Under the accrual method, companies charge warranty costs to operating expense in the year of sale.
D)Refusal to write-off permitting and/or project costs on impaired or abandoned landfills.

Question 37

There are several aspects of Enron fraud that are dealt with directly in SOX further connecting Enron to reform in the accounting profession.Which of the following is true?

A)Prohibiting the provision of internal audit service for audit clients.
B)Off-balance-sheet financing activities must be disclosed in the notes to the financial statements.
C)Related-party transactions require disclosure in the notes.
D)All of the above.

Question 38

Which of the following is NOT true according to Enron's case?

A)Fastow developed the concept of buying up oil and gas companies to increase Enron's reserves for future sale.
B)Fastow worked to structure ventures that met the conditions under GAAP to keep the partnership activities off Enron's books and on the separate books of the partnership.
C)Fastow created SPE that borrowed money from banks and transferred to Enron in a sale of an operating asset no longer needed by Enron.
D)The SPE created by Fastow enabled Enron to keep debt off its books while benefiting from transfer and use of the cash borrowed by the SPE.

Question 39

Which of the following is NOT a technique used by Enron to manage earnings?

A)Used reserves to increase earnings when reported amounts were too low.
B)Deliberately over stated the allowance for uncollectible and adjusted it downward in future years.
C)Used mark-to-market estimates to inflate earnings in violation of GAAP.
D)Selected which operating assets to "sell" to the SPEs, affecting the gain on transfer and earnings effect.

Question 40

Which of the following is NOT an earnings management technique?

A)Recording revenue the customer is obligated to pay
B)Recording revenue when future services remain to be provided
C)Recording sales that lack economic substance
D)Including investment income or gains as part of revenue

Question 41

Explain when earnings management may be an ethical practice.

Question 42

Which of the following is NOT McKee's explanation of "earnings management"?

A)A smooth net income by choice does not reflect what investors and creditors need or want to know since it masks true performance.
B)It creates a more stable and predictable earnings stream by smoothing net income.
C)It is a reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results.
D)Earnings management reflects a conscious choice by management to smooth earnings over time and it does not include devices designed to "cook the books."

Question 43

The legal issue in the CellCyte Genetics Corporation case was:

A)Making false and misleading statements in several SEC filings
B)Making false and misleading statements in a court trial
C)Privity
D)Scienter

Question 44

Explain each of the seven financial shenanigans described by Schilit.Be sure to give an example of each one.

Question 45

The accounting issue in the Cubbies Cable case with respect to cable installations costs is closest to the accounting issue in which case?

A)Enron
B)Gemstar TV Guide
C)Xerox
D)WorldCom

Question 46

The accounting rule for deferring profit on a sale-leaseback agreement such as the one dealt with in the Florida Transportation case can best be described as:

A)The seller-lessee can defer profit on a sale-leaseback transaction if the seller gives up substantially all of the use of the property through the leaseback.
B)The seller-lessee can defer profit on a sale-leaseback transaction if the seller retains substantially all of the use of the property through the leaseback.
C)Profit can be deferred if the upfront costs exceed future revenues.
D)Profit can be deferred if initial revenue exceeds future costs.

Question 47

In the Xerox case, the leases Xerox had signed met the criteria under SFAS No.13 to be accounted for as:

A)Capital leases
B)Operating leases
C)Bargain purchase option leases
D)Sales-type leases

Question 48

The former CEO of Vivendi Universal, Jean-Marie Messier, used as his defense in the case that:

A)His actions were protected by attorney-client privilege
B)While some of his actions may have turned out to be wrong, there never was an intent to defraud
C)While some of his actions may have turned out to be wrong, he did the best that he could to save the company from certain bankruptcy
D)He adhere to the business judgment rule and met his fiduciary obligations
Essay Questions

Question 49

The main accounting issues in the Nortel Networks case were:

A)Premature revenue recognition and hidden cash reserves
B)Capitalization of operating expenses and hidden cash reserves
C)Premature revenue recognition and off-balance-sheet entities
D)Capitalization of operating expenses and off-balance-sheet entities

Question 50

Who identifies seven common financial shenanigans?

A)Schipper
B)Schilit
C)Levitt
D)McKee

Question 51

"Earnings management either ignores or does not consider the rights of the investors and creditors to receive accurate, reliable and transparent financial statements." This statement is from:

A)A virtue perspective
B)A utilitarian perspective
C)A rights perspective
D)A materiality perspective

Question 52

Which of the following is NOT a motivation to manage earnings in the Lucent Technology case?

A)Realize revenue
B)Meet predictions of outside securities analysts
C)Meet internal sales target
D)Obtain sales bonus

Question 53

Which of the following was not an accounting issue in the Sunbeam case?

A)Cookie jar reserves
B)Channel stuffing
C)Bill and hold sales
D)Swap transactions

Question 54

Discuss all the factors an auditor should consider in making a materiality judgment.

Question 55

The legal issue in the Altris Software v PricewaterhouseCoopers case that failed to be proved by the plaintiffs was:

A)Privity
B)Ordinary negligence
C)Scienter
D)Due care

Question 56

In the Sweat Hog Construction case, the company tried to manipulate earnings through the use of which accounting technique?

A)Cookie jar reserves
B)Lease capitalization
C)Percentage of completion method
D)The Big Bath Theory

Question 57

Many of the cases discussed in the chapter address the issue of swap transactions.What is a swap transaction? What criteria should be used to determine how and when to record revenue on swap transactions? Describe the facts of any one case in the book with respect to proper recording for revenue in swap transactions.

Question 58

The swap transactions used in the Solutions Network case to manage earnings can best be described as:

A)Going to a swap meet and capitalizing purchases instead of expensing them immediately against swap revenue
B)Recording revenue on software systems transactions in an earlier period than when obligated to buy the same in a later period
C)Using a cookie jar reserve to delay the recording of revenue into a later period
D)Recording as operating revenue on onetime gains from the sale of underperforming assets

Question 59

The amount and size of earnings restatements were relatively high in the early and mid-2000s.Explain the reasons that these instances were frequent and amounts high during that period of time.

Question 60

The element of the fraud triangle most directly dealt with in the Excello Telecommunications case is:

A)Pressure/Incentives
B)Opportunity
C)Rationalization
D)Materiality

Question 61

Assume you were in Sherron Watkins' position and you informed Ken Lay that the company might implode as a result of the accounting scandal.After an investigation by the lawyers who said there was nothing to worry about, Lay told you he would take no steps to act on your concerns.Use the relevant elements of the decision making model described in chapter 2 including stakeholder and ethical considerations and decide on a course of action for Watkins.

Question 62

Evaluate the ethics at Enron and by those in top management with respect to its operations and accounting and financial reporting techniques.

Question 63

Use the fraud triangle to evaluate the actions by those in top management at Enron as the accounting fraud unfolded.

Question 64

Steve is quickly moving up in the accounting department of RAC Inc.It is yearend; he has just received news that the estimates of the estimated useful life and salvage values were wrong and must be changed.Of course, that changes the depreciation expense and accumulated depreciation.Steve calls his wife to explain why he will be late again.Now is he is pondering on a comment his wife made.She said "I'm no accountant; but after four years, you would think that the company could get done how its estimates affect expenses and those other accounts." What might the company be doing and what should Steve do from an ethical reasoning view?

Question 65

The quality of financial reporting is an important issue in the chapter.Explain how and why the quality of financial reporting is an underlying issue in the frauds discussed in the chapter.

Question 66

Select either the Xerox or Lucent frauds described in the chapter and explain the accounting techniques used to commit fraud.