Deck 6: Earnings Management

Question 1

A Company showed a large restructuring charge on its income statement in 2011 and has experienced a constantly rising earnings trend since that time. This would most nearly represent an example of

A) cookie jar reserves.
B) creative acquisition accounting.
C) big bath accounting.
D) using immaterial transactions to increase reported earnings to meet analysts' expectations.

Answer 1

C

Question 2

Recording as an asset expenditures that have no future economic benefit is an example of

A) strategic matching.
B) change in methods or estimates with full disclosure.
C) non-GAAP accounting.
D) a fictitious transaction.

Answer 2

C

Question 3

Earnings management through strategic matching is best exemplified by

A) changing the useful life of a depreciable asset.
B) timing transactions such that large one-time gains and losses occur in the same quarter.
C) changing the interest rate used in accounting for leases without describing the change in the notes to the financial statements.
D) capitalizing as assets expenditures that have no future economic benefit.

Answer 3

B

Question 4

Which of the following items of the earnings management continuum is in the correct order?

A) Strategic matching, change in methods or estimates with full disclosure, non-GAAP accounting
B) Strategic matching, change in methods or estimates with little of no disclosure, fictitious transactions
C) Change in methods or estimates with little or no disclosure, non-GAAP accounting, fictitious transactions
D) Change in methods or estimates with full disclosure, non-GAAP accounting, fictitious transactions

Question 5

Which of the following typically is not associated with a change in estimate for accounting purposes?

A) Return on pension fund
B) Useful life of a depreciable asset
C) Bad debt expense
D) Change in calculating depreciation from straight-line to sum-of-the-years'-digit

Question 6

The cost of capital is defined as the

A) simple average of the interest rates of all debt outstanding.
B) simple average of the cost of debt and equity.
C) weighted average of the interest rates of all debt outstanding.
D) weighted average of the cost of debt and equity.

Question 7

"Purchased in-process research and development" is typically associated with

A) creative acquisition accounting.
B) cookie jar reserves.
C) proforma earnings amounts.
D) big bath accounting.

Question 8

Which of the following earnings management techniques is frequently associated with start-up companies?

A) Recording immaterial adjustments that cause earnings to meet analysts' expectations.
B) Recording extremely high warranty expense when earnings are high.
C) Recognizing revenue when a contract is signed and before goods are delivered or services are provided.
D) Expensing purchased in-process research and development.

Question 9

Most companies that engage in earnings management typically do not go beyond which of the following activities on the earnings management continuum?

A) Strategic matching
B) Change in methods or estimates with full disclosure
C) Change in methods or estimates with little or no disclosure
D) Non-GAAP accounting

Question 10

Which of the following is typically associated with cookie jar reserves?

A) Purchased in-process research and development
B) Recognizing very high bad debt expense when earnings are high
C) Recognizing revenue when a contract is signed prior to delivery of goods or performance of services
D) Proforma earnings

Question 11

Which of the following is true?

A) Cash flow data is superior to earnings under the accrual basis in predicting long-term performance of an entity.
B) Earnings under the accrual basis is superior to cash flow data in predicting short-term performance of an entity.
C) Earnings under the accrual basis is superior to cash flow data in predicting long-term performance of an entity.
D) Cash flow data is superior to earnings under the accrual basis in predicting both short- and long-term performance of an entity.

Question 12

The GAAP Oval best represents the

A) fact that only one true earnings number exists.
B) flexibility managers have within GAAP to report one earnings number from among many possibilities.
C) philosophy that earnings management within limits is ethical.
D) fact that GAAP is not subject to interpretation.

Question 13

Which of the following organizations has recommended that entities provide a reconciliation to GAAP net income whenever reporting proforma numbers?

A) Financial Executives International
B) Auditing Standards Board
C) Financial Accounting Standards Board
D) Accounting Standards Executive Committee

Question 14

Deferring the recognition of revenue for which the earnings process is complete is an example of

A) "big bath" accounting.
B) strategic matching.
C) a change in an accounting estimate.
D) a "cookie jar" reserve.

Question 15

Which of the following accounts would not be affected if a company failed to report returns of merchandise sold?

A) Sales returns
B) Sales allowances
C) Cost of goods sold
D) Inventory

Question 16

Excessive earnings management typically begins as a result of

A) a regulatory investigation.
B) pressure to meet the expectations of stakeholders.
C) a downturn in business.
D) a violation of generally accepted accounting principles.

Question 17

Which of the following services offered by investment firms have some states declared to be incompatible with generating forecasts of company earnings?

A) Only 3
B) Only 4
C) 3 and 4
D) 1, 2, 3, and 4

Question 18

Which of the following typically involves the use of non-GAAP accounting?

A) Strategic matching
B) A change in accounting estimate that is fully disclosed
C) Proforma earnings
D) A change in accounting principle that is fully disclosed

Question 19

Excluding some revenues, expenses, gains, losses from the earnings figure calculated using generally accepted accounting principles is an example of

A) income smoothing.
B) "big bath" accounting.
C) a "cookie jar" reserve.
D) proforma earnings.

Question 20

Which of the following is the SEC authorized by Congress to do?

A) Only III
B) I and III
C) I and II
D) I, II, and III

Question 21

Which of the following is not a function of a financial analyst?

A) Providing buy recommendations on a company's stock
B) Providing sell recommendations on a company's stock
C) Generating forecasts of company earnings
D) Serving as an investment banker for a company for which the analyst is providing research coverage

Question 22

Recent accounting scandals suggest the need for care on the part of an independent auditor in accepting new clients. The independent auditor needs to know both the business of and the personnel employed by a prospective client. All other control procedures are fruitless if a CPA chooses to serve an undesirable client. The damage suffered as a result of associating with an undesirable client can be irreparable.
Discuss some key issues an independent auditor should consider in the client acceptance decision.

Question 23

The term "earnings quality" refers to the ability of reported earnings to predict an entity's future earnings. To enhance predictability, financial analysts attempt to distinguish between a company's transitory earnings (transactions or events not likely to occur in the future) and its permanent earnings.
It is tempting to assume that transitory earnings are represented primarily by discontinued operations and extraordinary items. All items of revenue and expense included in operating income may not be permanent, however. Restructuring costs often are included in determining operating income, yet may or may not continue in the future.
Required:
Do you think restructuring costs represent transitory earnings or permanent earnings? Explain.

Question 24

Research has shown that numerous companies manage their earnings. A variety of earnings management techniques are available ranging from income smoothing to outright fraud.
Define income smoothing and explain how it is implemented.

Question 25

One of the five techniques of earnings management identified by the Securities and Exchange Commission relates to materiality. Independent auditors have traditionally used arbitrary quantitative benchmarks to define how large an amount must be to be considered material.
During the course of auditing the financial statements of a company, an auditor finds some misstatements in the client's financial statements. When combined, the misstatements, result in a 4% overstatement of net income and a $.02 (4%) overstatement of earnings per share. The auditor's materiality threshold is 5%, that is, an item in the financial statements must be misstated by more than 5% to be considered a material deviation from generally accepted accounting principles. On the basis of the established materiality threshold, the auditor concludes that the deviation from GAAP is immaterial and the accounting is permissible.
Define the term "materiality" and explain whether the auditor is justified in the conclusion that the accounting proposed by the client is permissible.

Question 26

Which of the following regarding the weighted-average cost of capital is true?

A) The tax effect of preferred stock dividends should be included in the calculation of weighted-average cost of capital.
B) The tax effect of common stock dividends should be included in the calculation of weighted-average cost of capital.
C) The tax effect of debt should be included in the calculation of the weighted-average cost of capital.
D) Taxes do not affect the weighted-average cost of capital.

Question 27

The Securities and Exchange Commission (SEC) has the right granted to it by Congress to issue accounting standards. The Commission has exercised this right on a relatively infrequent basis. The SEC is not a passive observer to the financial accounting standard setting process, however.
Explain the general mission of the SEC and how the SEC fulfills its mission as regards financial reporting specifically.

Question 28

You are auditing a company whose management has intentionally made adjustments to various financial statement items that are not in accordance with generally accepted accounting principles. This behavior has occurred over a number of accounting periods. None of the individual adjustments by itself is material and the aggregate effect on the financial statements taken as a whole is immaterial. Top management of the client are aware of these misstatements and consider them part of their strategic management of earnings.
Explain how you as the independent auditor should respond to this situation.

Question 29

Which of the following is true regarding the weighted-average cost of capital?

A) A company may have two weighted-average costs of capital if the firm's capital structure is so large that new common stock must be sold.
B) The book value of the components of capital should always be used to calculate the weighted-average cost of capital.
C) The cost of common equity is lower than the cost of retained earnings.
D) The cost of preferred stock is adjusted for the tax deduction associated with preferred dividends.

Question 30

Recognizing more bad debt expense in a year than is necessary in order to have flexibility in recognizing bad debt expense in a future year is an example of

A) a big bath charge.
B) a cookie jar reserve.
C) creative acquisition accounting.
D) premature recognition of revenue.

Question 31

The practice of carefully timing the recognition of revenues and expenses to even out the amount of reported earnings from one year to the next is called

A) revenue recognition.
B) income smoothing.
C) restructuring.
D) accrual-basis accounting.

Question 32

Recent accounting scandals have raised concerns over the quality and transparency of financial accounting and reporting in the United States. Critics of what is termed the "rules-based" system currently used in the U.S. cite the increasingly detailed and complex nature of rule-driven accounting pronouncements. These critics suggest that the United States should adopt a principles-based system similar to that of the International Accounting Standards Board.
Explain what is meant by a principles-based system and the advantages and disadvantages of such a system.

Question 33

Which of the following is true?

A) Companies can raise common equity only by issuing new shares of common stock.
B) There is no opportunity cost associated with use of retained earnings as a source of common equity.
C) Most large mature firms issue new shares of common stock on a regular basis.
D) Companies can raise common equity by issuing new shares of common stock and through retained earnings.

Question 34

The following summarized information is available for Central Plains Company at December 31 of the current year:

The debt of Central Plains has a before-tax cost rate of 11.5%, preferred stock has a cost of 12.1%, and common equity has a cost of 14.2%. The tax rate for Central Plains is 34%.
Calculate the weighted average cost of capital for Central Plains at December 31 of the current year.

Question 35

Internal earnings targets represent an important tool in motivating managers to increase sales efforts, control costs, and use resources more efficiently. Such internal targets also can cause managers to resort to extreme measures in order to meet goals established by upper management. Earnings management often appears in a variety of forms as a means of reaching these internal goals.
Earnings management also is associated with earnings-based internal bonus plans which are also a form of internal target.
Explain how earnings management is related to earnings-based internal bonus plans and how managers behave in response to such plans.

Question 36

The following summarized information is available for Essex Company at December 31 of the current year:

The debt of Essex has a before-tax cost rate of 12%, preferred stock has a cost of 12.3%, and common equity has a cost of 14.6%. The tax rate for Essex is 34%.
Calculate the weighted average cost of capital for Essex at December 31 of the current year.

Question 37

Which of the following is true about a pro forma earnings number?

A) A pro forma earnings number is in total conformity with GAAP.
B) A pro forma earnings number is a forecast of earnings in future periods.
C) Reporting pro forma earnings by companies subject to SEC regulation is illegal.
D) A pro forma earnings number is regular GAAP earnings with certain exclusions.

Question 38

WM is a waste disposal company. Explain the effect the following actions of the management of WM Company might have in managing earnings:

Question 39

Several catastrophic accounting failures have occurred over the last few years. Although the details of each failure is different, each case stems from attempts to manage earnings and thus all of these failures have common elements.
One of the elements identified in these earnings management meltdowns is the auditor's calculated risk.
Explain what is meant by the term "the auditor's calculated risk".

Question 40

Which of the following is incorrect?

A) The after-tax cost of debt for a firm with losses is equal to the interest rate on the debt.
B) Most debt is placed privately and thus there is no flotation cost.
C) Flotation costs for preferred stock are higher than for debt.
D) Firms always pay dividends on their common stock issues because of the ease with which common shareholders can assume control of the firm.

Question 41

Managers of many companies frequently provide a pro forma earnings amount in conjunction with their annual or quarterly earnings calculated in accordance with GAAP. Managers claim that pro forma earnings numbers more fairly reflect a company's performance.
Required:

Question 42

Statement of Financial Accounting Concepts No. 1, "Objectives of Financial Reporting by Business Enterprises," identifies investors and creditors as the primary users of financial reporting information. Investors in public companies express their opinions about an entities equity securities through organized exchanges such as the New York Stock Exchange. Given that investors represent one of the two primary groups to which financial reporting is directed, accountants and auditors preparing and opining on, respectively, the financial statements of public companies should be aware of the effects of the quality of financial reporting on stock prices.
Required:
Identify four major periods of decline in worldwide stock prices for the years 1997 through 2002 and discuss the role (if any ) of financial reporting in these declines.

Question 43

Earnings management can range from methods that suggest astute management to outright fraud.
Required:

Question 44

The existence of earnings management techniques does not justify their use. Some would say that any form of earnings management is unethical. Others would say that some amount of earnings management within certain bounds is necessary to survival in the modern world.
Required:
Is earnings management ethical?

Question 45

Net income is a key number for shareholders, creditors, and analysts alike. Indeed, analysts' projections of net income for a company are viewed as a standard a company must achieve for a period of time. Failure to achieve this standard can have devastating effects on a company's stock price and its management.
The importance of net income in the eyes of analysts and others can tempt managers to take steps to ensure that the appropriate level of net income is achieved. The process of manipulated net income to achieve a desired level of earnings is referred to as earnings management.
Required:
List and explain the economic motivations for earnings management.

Question 46

The cost of capital is the cost a company bears to obtain external financing. A company's cost of capital is critical because it determines which long-term projects are profitable for the entity to undertake. The higher the cost to obtain funds, the fewer the long-term projects are profitable for a company to pursue.
Required:
Explain the role of financial statements generally and the roles of the FASB, the AICPA, the SEC, and the IASB in lowering the cost of capital.