Deck 6: Quality of Accounting Information and Adjustments to Reported Financial Statement Data

Question 1

Under new accounting standards passed in 2006 firms must report changes in accounting principle in the current and prior years as if the new accounting principle had been applied all along. The rational for this change was

A) using the same accounting principle in current and prior periods enhances the information content of reported earnings in forecasting future earnings.
B) conservatism.
C) comparability.
D) materiality.

Answer 1

A

Question 2

Which of the following is not considered a motive to manage earnings?

A) To create optimal manager compensation payments.
B) To create optimal job security for senior management.
C) To create optimal measures of assets and liabilities for balance sheet purposes.
D) To manage reported earnings in order to reduce industry-specific actions.

Answer 2

C

Question 3

Firm's choices and estimates within GAAP should be determined by

A) how the industry operates.
B) the firm's underlying economic circumstances.
C) SEC interpretations regarding specific choices.
D) the firm's auditor.

Answer 3

B

Question 4

The date on which a firm commits itself to a formal plan to dispose of a segment is the

A) disposal date
B) measurement date
C) commitment date
D) sale date

Question 5

In a restructuring it is possible that managers may use the opportunity to write down assets that do not even relate directly to the restructuring action. Why might a manager decide to write down an asset that is not included in the restructuring action?

A) The manager is practicing conservatism.
B) The write down relieves future periods of depreciation expense, which increases cash flows.
C) Normally the stock market reacts positively to restructuring and the greater the amount the better.
D) The write down relieves future periods of depreciation expense, which increases earnings.

Question 6

Gains and losses that appear in Other Comprehensive Income are the result of value changes

A) only in non-current assets and liabilities.
B) in stockholders' equity.
C) driven by difficult measurement issues.
D) that have not been realized in a market transaction.

Question 7

When a company makes a change in an estimate that it has used in its financial statements, it should account for the change by

A) retroactively restating all prior financial statements
B) treat the change as a cumulative effect change in accounting estimate
C) spread the effect of the change over the current and future periods
D) companies are not allowed to make changes to estimates

Question 8

Which of the following items is consistent with earnings being informative about current performance and informing the analyst that level of current earnings are not sustainable?

A) The firm recognizes an unexpected gain
B) The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates.
C) The firm recognizes additional expenses this period due to pre-opening costs associated with new stores.
D) The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

Question 9

Which of the following does not describe an extraordinary gain or loss

A) infrequent in occurrence
B) peripheral to the company's core business
C) unusual in nature
D) material in amount

Question 10

Earnings that are high quality would

A) be informative about current performance and provide information about the long-run sustainability of profits.
B) be informative about past performance and provide information about the long-run sustainability of profits.
C) be informative about current performance and provide information about the long-run sustainability of assets.
D) be informative about past performance and provide information about the long-run sustainability of assets and liabilities.

Question 11

Which of the following is not a characteristic of an extraordinary item?

A) Unusual in nature
B) Infrequent in occurrence
C) Material in amount
D) Subject to a firm commitment

Question 12

When evaluating the quality of accounting information, an analyst should consider all of the following except:

A) reliability of the measurements made
B) adequacy of disclosures
C) comparability of estimates
D) economic faithfulness of the measurements made

Question 13

During July 2007 Red Company decides to dispose of one of its subsidiaries which qualifies for accounting as a discontinued operation. At the July 2007 measurement date Red Company estimates that it will report net losses of $1,500,000 dollars from the measurement date until the disposal date which is expected to be in April 2008. In addition, Red estimates that it will lose $300,000 on the sale of the segment. How much gain or loss on discontinued operations will Red report in its 2007 income statement (net of income taxes)?

A) $1,500,000 loss
B) $0
C) $1,800,000 loss
D) $300,000 loss

Question 14

Which of the following items is consistent with earnings being informative about current performance and but not informative about future earnings?

A) The firm recognizes an unexpected gain
B) The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates.
C) The firm recognizes additional expenses this period due to pre-opening costs associated with new stores.
D) The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

Question 15

One definition of earnings management is that it occurs when managers use

A) judgment in financial reporting to alter financial reports to mislead stakeholder.
B) an accounting method that is inconsistent with other industry members.
C) more conservative accounting estimates than other companies.
D) pro forma accounting results as opposed to GAAP results.

Question 16

Many times a financial analyst may decide to make adjustments to the financial statements in order to make the statements more useful. Which of the following would not require an adjustment to the financial statement?

A) A company signs a new contract with a customer.
B) A delivery company incurs a loss from disposition of used delivery trucks.
C) A company changes the useful life of its equipment from 5 years to 8 years.
D) A company incurs a charge related restructuring its operations.

Question 17

During July 2007 Red Company decides to dispose of one of its subsidiaries which qualifies for accounting as a discontinued operation. At the July 2007 measurement date Red Company estimates that it will report net income of $200,000 dollars from the measurement date until the disposal date which is expected to be in April 2008. In addition, Red estimates that it will lose $300,000 on the sale of the segment. How much gain or loss on discontinued operations will Red report in its 2007 income statement (net of income taxes)?

A) $200,000 gain
B) $0
C) $100,000 loss
D) $300,000 loss

Question 18

Which of the following items is consistent with earnings not being informative about current performance but are informative about future earnings?

A) The firm recognizes an unexpected gain
B) The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates.
C) The firm recognizes additional expenses this period due to pre-opening costs associated with new stores.
D) The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

Question 19

Accounting information should provide a fair and complete representation about a number of a firm's characteristics, which of the following is not one of those characteristics?

A) risk
B) position
C) performance
D) conservatism

Question 20

Which of the following items is consistent with earnings being informative about current performance and informing the analyst that level of current earnings is sustainable?

A) The firm recognizes an unexpected gain
B) The firm recognizes a fair value gain on a financial asset as a result of a favorable move in interest rates.
C) The firm recognizes additional expenses this period due to pre-opening costs associated with new stores.
D) The firm experiences a large jump in sales and earnings as a result of successful research and development of new products.

Question 21

The _________________________ is the date on which a firm commits itself to a formal plan to dispose of a business segment.

Question 22

Some firms attempt to maximize the amount of restructuring charge in a particular year, analysts refer to this as the _________________________ approach.

Question 23

When a long-lived asset loses its ability to generate future benefits GAAP requires firms to write down the assets to their fair values and recognize an ______________________________ in income from continuing operations.

Question 24

When evaluating the quality of accounting information the user should consider the ____________________ of the firm's disclosures.

Question 25

Quality accounting information should be informative as to both the __________________________________________________ of the current period's earnings and the long-run sustainability of profits.

Question 26

When evaluating the quality of accounting information the user should consider the reasonableness of the ____________________ made in applying GAAP.

Question 27

An _________________________ occurs when the carrying amount of a company's long-lived assets are not recoverable.

Question 28

A ____________________ of operations differs from a discontinuation of operations because the firm continues to operate in the business segment.

Question 29

Gains and losses differ from revenues and expenses in that they are produced by ____________________ activities.

Question 30

Under current GAAP unrealized gains and losses from four balance sheet items are reported in accumulated other comprehensive income or loss. Which of the following is not one of the balance sheet items?

A) Derivatives held as cash flow hedges.
B) Deferred tax assets related to net operating loss carryforwards.
C) Minimum pension obligations.
D) Investment securities classified as available for sale.

Question 31

Accounting information should be a fair and complete representation of the firm's economic ____________________, ____________________, and ____________________.

Question 32

When evaluating the quality of accounting information the user should consider the ____________________ of the measurements made.

Question 33

When evaluating the quality of accounting information the user should consider the _____________________________________________ of the measurements made.

Question 34

Accounting information should provide relevant information to forecast the firm's expected future earnings and _________________________.

Question 35

The _________________________ is the date of closing the sale, if the firm intends to sell the segment, or the date operations cease, if the firm intends to abandon the segment.

Question 36

Earnings are informative if they signal the portion of current period's due to a new product and the additional earnings in the future as a result of the ____________________ of this new earnings stream.

Question 37

An extraordinary gain or loss is unusual in nature, _____________________________________________, and material in amount.

Question 38

Quality accounting information seeks to maximize relevance and economic faithfulness, subject to the constraints of the ____________________ of the measurements.

Question 39

A ______________________________ is accounted for by spreading the effect of the prior year's misstatement over the current and future periods.

Question 40

Under current GAAP unrealized gains and losses from four balance sheet items are reported in ___________________________________________________________________________.

Question 41

Bank5 recognized an extraordinary loss from the settlement of a lawsuit with Fifth Street Bank that it had impeded on a processing patent. The extraordinary loss was in the amount of $3,250,000 and Bank5 Corporation has an effective tax rate of 35%. Bank5 paid the settlement immediately and recognized the tax benefit as a receivable to offset the current period's taxes.
Instructions:

Question 42

GAAP requires that changes in estimates be accounted for by recognizing the effect ________________________________________ period(s).

Question 43

____________________ represents the concept of being able to compare financial statement data across years for any particular firm.

Question 44

Cannon Corp., a textile manufacturer, reported net income of $258,000 in 2007. During 2007 Cannon reported a gain of $29,800 from the sale of three used delivery trucks. The gain was included as part of income from continuing operations. Assuming that the gain is a one-time event and that Cannon has an effective tax rate of 35% calculate Cannon's adjusted net income. Show all of your calculations for credit.
In addition, discuss why analysts might make an adjustment of this type.

Question 45

On July 15, 2004 Ryan Services decided to sell its agricultural business and focus on its landscape equipment business. The sale of the agricultural business qualifies for discontinued operations accounting treatment. On November 11, 2004 Ryan Services signs a firm contract to sell the agricultural business to Alfalfa Inc. on March 10, 2005. For each of the situations listed discuss how Ryan Services would report the discontinued operations in its December 31, 2004 income statement. (You may disregard tax issues with respect to the sale.)
Situation 1: For the period January 1, 2004 to July 15, 2004 Ryan Services reports that the agricultural business lost $3.2M. From July 16, 2004 to November 11th, 2004 Ryan Services reports that the agricultural business loses an addition $1.4 million dollars. At the end of the 2004 Ryan estimates that it will lose an additional $800,000 on the sale of the agricultural business when it is finally completed in 2005.
Situation 2: For the period January 1, 2004 to July 15, 2004 Ryan Services reports that the agricultural business had a profit of $1.5M. From July 16, 2004 to November 11th, 2004 Ryan Services reports that the net income from the agricultural business was $600,000 dollars. At the end of the 2004 Ryan estimates that the sale of the agricultural business will result in a gain of $1.7 million dollars when it is finally completed in 2005.
Situation 3: For the period January 1, 2004 to July 15, 2004 Ryan Services reports that the agricultural business lost $3.2M. From July 16, 2004 to November 11th, 2004 Ryan Services reports that the agricultural business loses an addition $1 million dollars. However, at the end of the 2004 Ryan estimates that the sale of the agricultural business will result in a gain of $1.3 million dollars when it is finally completed in 2005.

Question 46

Geyser Corp. reported net income of $390,000 in 2007. During 2007 Geyser reported a loss of $72,000 from a peripheral activity. The loss was included as part of income from continuing operations. Assuming that the loss is a one-time event and that Geyser has an effective tax rate of 35% calculate Geyser's adjusted net income. Show all of your calculations for credit.
In addition, discuss why analysts might make an adjustment of this type.

Question 47

Profit Corp. manufactures telecommunication equipment and has been profitable each year for the past ten years. During 2005 the company saw its core market decline sharply when a competitor introduced a significant new product technology. In response to the decline in business Profit Corp. announced a major restructuring of its operations. The restructuring plan which would be implemented in 2005 would involve the following changes (all of the charges are material):
Profit Corp. has never previously restructured its operations and believes that it can return to profitability within two years based on its current research and development activity.
Required:

Question 48

Healy and Wahlen state that one type of earnings management occurs when managers use judgement in financial reporting to alter financial reports in order to mislead some stakeholder about the economic performance of the company. Earnings management is a consequence of a judgement by management which results in lower economic information content of the financial reports.
Discuss five motives that encourage managers to practice earnings management.

Question 49

Many times an analyst will have to make judgments as to whether to include unrealized gains and losses when assessing earnings persistence and predicting future profitability. Discuss the case for and the case against including unrealized gains and losses as part of sustainable earnings when examining earnings persistence and future profitability.

Question 50

Summarize how the following information about Clash Corp.s restructuring would affect the balance sheet and income statement summary chart below. Clash Corp.'s restructuring will take approximately 18 months and was announced on March 15, 2006:

Question 51

Achieving comparability in financial reporting is important to the analysis of multinational firm. However, the data from the reconciliation of foreign firms financial statement to U.S. GAAP must be careful interpreted. What types of things complicate the analysis of multinational firms?

Question 52

Healy and Wahlen state that one type of earnings management occurs when managers use judgement in financial reporting to alter financial reports in order to mislead some stakeholder about the economic performance of the company. Earnings management is a consequence of a judgement by management which results in lower economic information content of the financial reports.
Discuss four reasons that discourage managers from practicing earnings management.