CHAPTER 11
Financial Reporting Quality

Solutions

  1. B is correct. Financial reporting quality pertains to the quality of information in financial reports. High-quality financial reporting provides decision-useful information, which is relevant and faithfully represents the economic reality of the company’s activities. Earnings of high quality are sustainable and provide an adequate level of return. Highest-quality financial reports reflect both high financial reporting quality and high earnings quality.
  2. 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.
  3. 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 of little use in assessing 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.
  4. 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. 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.
  5. A is correct. Earnings that result from non-recurring activities are unsustainable. Unsustainable earnings are an example of lower-quality earnings. Recognizing earnings that result from non-recurring activities is neither a biased accounting choice nor indicative of lower quality financial reporting because it faithfully represents economic events.
  6. B is correct. At the top of the quality spectrum of financial reports are reports that conform to GAAP, are decision useful, and have earnings that are sustainable and offer adequate returns. In other words, these reports have both high financial reporting quality and high earnings quality.
  7. 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 chapter). The lowest-quality reports portray fictitious events, which may misrepresent the company’s performance and/or obscure fraudulent misappropriation of the company’s assets.
  8. B is correct. Deferring research and development (R&D) investments into the next reporting period is an example of earnings management by taking a real action.
  9. B is correct. High-quality financial reports offer useful information, meaning information that is relevant and faithfully represents actual performance. Although low earnings quality may not be desirable, if the reported earnings are representative of actual performance, they are consistent with high-quality financial reporting. Highest-quality financial reports reflect both high financial reporting quality and high earnings quality.
  10. 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 that period would most likely exhibit an upward bias.
  11. C is correct. Accounting choices are considered conservative if they decrease the company’s reported performance and financial position in the period under review. Conservative choices may increase the amount of debt reported on the balance sheet. They may decrease the revenues, earnings, and/or operating cash flow reported for the period and increase those amounts in later periods.
  12. A is correct. Conservatism reduces the possibility of litigation and, by extension, litigation costs. Rarely, if ever, is a company sued because it understated good news or overstated bad news. Accounting conservatism is a type of bias in financial reporting that decreases a company’s reported performance. Conservatism directly conflicts with the characteristic of neutrality.
  13. 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.
  14. B is correct. Managers may be motivated to understate earnings in the reporting period and increase the probability of meeting or exceeding the next period’s earnings target.
  15. C is correct. Typically, conditions of opportunity, motivation, and rationalization exist when individuals issue low-quality financial reports. Rationalization occurs when an individual is concerned about a choice and needs to be able to justify it to herself or himself. If the manager is concerned about a choice in a financial report, she or he may ask for other opinions to convince herself or himself that it is okay.
  16. C is correct. In a period of strong financial performance, managers may pursue accounting choices that increase the probability of exceeding earnings forecasts for the next period. By accelerating expense recognition or delaying revenue recognition, managers may inflate earnings in the next period and increase the likelihood of exceeding targets.
  17. B is correct. Motivation can result from pressure to meet some criteria for personal reasons, such as a bonus, or corporate reasons, such as concern about future financing. Poor internal controls and an inattentive board of directors offer opportunities to issue low-quality financial reports.
  18. A is correct. The possibility of bond covenant violations may motivate managers to inflate earnings in the reporting period. In so doing, the company may be able to avoid the consequences associated with violating bond covenants.
  19. 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 a certain level of performance and corporate concerns about future financing 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.
  20. 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.
  21. 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.
  22. B is correct. If a company wants to increase reported earnings, the company’s managers may reduce the allowance for uncollected accounts and the related expense reported for the period. Decreasing the useful life of depreciable assets would increase depreciation expense and decrease earnings in the reporting period. Classifying a purchase as an expense, rather than capital expenditure, would decrease earnings in the reporting period. The use of accrual accounting may result in estimates 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 managed by the company to present a desired financial picture.
  23. 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 identify 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 before goods are shipped to customers, may be a warning sign of accounting malfeasance.
  24. A is correct. Managers can temporarily show a higher cash flow from operations by stretching the accounts payable credit period. In other words, the managers delay payments until the next accounting period. Applying all non-cash discount amortization against interest capitalized causes reported interest expenses and operating cash outflow to be higher, resulting in a lower cash flow provided by operations. Shifting the classification of interest paid from financing to operating cash flows lowers the cash flow provided by operations.
  25. 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.
  26. 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.
  27. C is correct. To extrapolate historical earnings trends, an analyst should consider making pro forma analytical adjustments of prior years’ earnings to reflect in those prior years a reasonable share of the current period’s restructuring and impairment charges.