Deck 7: Earnings Management and the Quality of Financial Reporting

Question 1

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

A) "Earnings management" is done to project smoother earnings from year to year.
B) Management emphasizes achieving long-term results to meet financial goals.
C) A Management uses "cookie-jar reserves each year."
D) The executives manipulate the earnings in order to match their predetermined target.

Answer 1

B

Question 2

Which of the following author(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

Answer 2

B

Question 3

Which of the following was not pointed to by the SEC as a motivation for fraud 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) Xerox top management overrode the internal control to manipulate earnings.
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.

Answer 3

B

Question 4

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 5

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 6

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

Question 7

Which of the following earnings management techniques were not used in the 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 8

Who said "the ethics issue might possibly be mitigated by clearly disclosing aggressive accounting assumptions in the financial statement disclosures?"

A) Hopwood et al
B) Thomas
C) Arthur Levitt
D) Belverd Needles
E) McKee

Question 9

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) Companies try to accelerate as much revenue as possible into early periods regardless of the effects on later periods
C) To smooth net income over time
D) To maximize compensation including bonuses

Question 10

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 these were used

Question 11

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 12

The SEC requires stealth restatements to be

A) Disclosed only in periodic reports.
B) Disclosed only in an 8-K report or amended 10-K/A or 10-Q/A.
C) Increased to more 50 % of restatements.
D) Disclosed in ten business days after determination of need for restatement.

Question 13

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 14

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 15

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

Question 16

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 17

Vorhies identities 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 18

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 19

Which of the following author(s) link earnings management to choices made in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent practices that are clearly intended to deceive others?

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

Question 20

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

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) Used channel stuffing to accelerate the recording of revenue into earlier periods
D) Inflated advertising revenue from nonmonetary and barter transactions

Question 21

What is the culture at Enron that 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 these

Question 22

Which of the following was 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 uncollectibles 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 23

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

A) All 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 engagement partner rotation.
C) Only U.S. companies are subject to the disclosure requirements of the Act.
D) All public companies must change auditors every ten years.

Question 24

What was 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

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 26

"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 27

Which of the following partnership that Enron created eventually lead to its demise?

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

Question 28

The main difference between a discretionary and nondiscretionary accrual is:

A) Discretionary accruals are items that management has full control over
B) Discretionary accruals are based on changes in the fundamental performance of the firm
C) Discretionary accruals arise from transactions considered normal for the firm
D) Discretionary accruals always lead to an increase in earnings

Question 29

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 these

Question 30

Inherent risk refers to:

A) The possibility that a material misstatement will occur within the reporting company's accounting information system
B) The possibility that a material misstatement that has occurred will not be detected on a timely basis by the company's control system
C) The possibility that a material misstatement that has occurred will not be caught be the independent auditor's testing
D) The possibility that a material misstatement will occur in the financial statements

Question 31

In the Matrixx Initiatives v. Siracusano case, the Supreme Court adopted the position about materiality that

A) It should always be determined only through qualitative evaluations
B) It should always be determined through quantitative evaluations
C) It should always be determined by considering whether the amount affects past financial statements
D) It should be determined by considering whether the total mix of information would be viewed by a reasonable investor as possibly accepting judgment

Question 32

According to AU 320, the evaluation of whether a misstatement could influence economic decisions of users

A) Is essential to determining whether to render an unmodified opinion
B) Is essential to determining whether the financial statements contain fraud
C) Is essential to determining whether such a misstatement is material
D) Is essential to determining whether there is a failed audit

Question 33

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 34

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 35

Which of the following was not true according to the Enron case?

A) Fastow developed the concept of buying up oil and gas companies to establish SPEs
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 SPEs that borrowed money from banks and transferred it to Enron in a sale of an operating asset no longer need 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 36

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 37

Accruals are potentially troublesome because:

A) They can lead to giving an unmodified audit opinion when it should have been modified
B) They provide an opportunity to manage earnings through aggressive or more conservative estimations
C) They always lead to fraud in financial statements
D) They provide an opportunity to shift debt off the books by setting up an SPE

Question 38

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) Thomas
D) Arthur Levitt
E) McKee

Question 39

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) SOX permitted the provision of internal audit service for audit clients
B) Off-balance-sheet financing activities were prohibited for all companies
C) Related-party transactions require disclosure in the notes
D) All of these

Question 40

"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 41

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

Question 42

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 43

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 44

The Diamond Foods case addresses each of the following issues except for:

A) Crop payable recorded in the wrong year
B) Increasing revenues but stagnating cash flows
C) Depreciation of almond trees
D) Clawbacks of stock and cash

Question 45

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 for certain bankruptcy
D) He adhere to the business judgment rule and met his fiduciary obligations
Essay Questions

Question 46

Explain when earnings management may be an ethical practice.

Question 47

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

Question 48

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

Question 49

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 50

The accounting shenanigan used in the Dell Computer case can best be described as:

A) Recording revenue from exclusivity payments too soon or of questionable quality
B) Shifting current revenue from exclusivity payments to a later period
C) Shifting future expenses to the current period as a special charge
D) Shifting current expenses to a later period

Question 51

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

Question 52

In the Sweat 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 accounting

Question 53

Your professor asks you to consider whether earnings management can be justified by arguing that the net benefits of managing earnings exceeds any harms that may occur. The professor is asking you to apply what reasoning methods to make the analysis?

A) Egoism
B) Act utilitarianism
C) Rule utilitarianism
D) Virtue

Question 54

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 55

You work for a company that always pushes the envelope with respect to reporting revenues and expenses. You often disagree with the company because its approach to reporting these amounts cannot be justified from a GAAP perspective. You are upset and are considering whether this is a company that has a culture you want to be part of. Which of the following best characterizes the ethical issues of concern?

A) Rights Theory
B) Moral blindness
C) Ethical Dissonance
D) Materiality

Question 56

The North Face case deals with materiality and how auditors employ that metric in an audit. The following are all true except:

A) North Face accounted for barter transactions with full normal margin recognized.
B) Crawford devised the 1997 barter transaction so that it was just beneath material threshold.
C) Crawford followed the GAAP methods that Deloitte suggested.
D) Deloitte proposed an adjusting entry for the 1997 barter transaction, but "passed" it as immaterial.

Question 57

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

Question 58

Debbie and Steve are discussing a lecture given by their ethics professor after class one day. The professor said that misstatements of earnings are always unethical. Debbie agrees with this situation but Steve does not. What statement might Steve make to best support his point of view?

A) It depends on whether the misstatements were made deliberately
B) It depends on whether a user relied on the financial statements
C) It depends on whether the statements lead to a modified or unmodified opinion
D) All are valid statements for Steve to support his point of view

Question 59

The Solway case looks at the accounting issue of:

A) Recording of accruals to manage earnings
B) Recording of asset impairments to manage earnings
C) Premature revenue recognition
D) Setting up SPEs

Question 60

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 61

The following is a definition of earnings management:
"Earnings management is recognized as attempts by management to influence or manipulate reported earnings by using specific accounting methods (or changing methods), recognizing one-time non-recurring items, deferring or accelerating expense or revenue transactions, or using other methods designed to influence short-term earnings." Explain what is meant by this statement in the context of the discussion in the chapter.
[This statement comes from an excellent article on the issue titled "Earnings Management and its Implications." You may want to discuss parts of the article with your students. The article can be found at: http://www.nysscpa.org/cpajournal/2007/807/essentials/p64.htm]

Question 62

Zynga makes free-to-play games and gets revenue from the sale of virtual goods for things like extending play sessions, personalizing game environments, accelerating game progress and sending gifts to friends. The company experienced deep declines in its user base during 2011-2013. At one point, plaintiffs in a lawsuit charged that Zynga executives falsely pumped up revenue and prospects so that insiders and underwriters could dump $593 million in personally-held stock.
The lawsuit alleges that the company changed its accounting methods shortly before the initial public offering to inflate short term earnings while executives hid emerging problems. Assuming the charges are true, do you believe Zynga management engaged in earnings management? How do you evaluate the ethics of its actions?

Question 63

Steve is quickly moving up in the accounting department of RAC Inc. It is year-end; he has just received news that the estimates of the estimated useful life and savage 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 a comment his wife made. She said "I'm no accountant; but after four years, you would think that the company could get it right how its estimates affect expenses and the relevant accounts." How might Steve interpret his wife's statement from an ethical perspective in the context of the facts?

Question 64

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 65

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.