Deck 2: Financial Reporting and Analysis

Question 1

Byfort Company reports the following in its financial statements:
$$\begin{array} { | l | c | c | } \hline & \underline { 2005 } & \underline { 2006 } \\\hline \text { Accounts Receivable, net } & \$ 34,289 \mathrm {~K} & \$ 29,678 \mathrm {~K} \\\hline \text { Net sales } & \$ 360,007 \mathrm {~K} & \$ 450,000 \mathrm {~K} \\\hline\end{array}$$ *All sales are on credit.

-How much sales would have been reported by the company in 2006 if Byfort would have been using cash accounting and not accrual accounting?

A) $445,389K
B) $454,611K
C) $484,289K
D) $488,900K

Answer 1

$454,611K

Question 2

Which of the following would require the filing of Form 8-K?
I) Major acquisition
II) Audited financial statements
III) Bankruptcy
IV) Change in management control

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

Answer 2

C

Question 3

Financial accounting data has some inherent limitations. Which of the following are limitations?
I) Not all economic events are easily quantifiable.
II) Many accounting entries rely heavily on estimates.
III) Historical cost can distort statements.
IV) Inflation can distort accounting data.

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

Answer 3

D

Question 4

Which of the following statements about accruals and cash flows is true?

A) All cash flows are value relevant.
B) Cash flows cannot be manipulated.
C) Cash flows are more reliable than accruals.
D) All accrual accounting adjustments are value irrelevant.

Question 5

10-K reports are:

A) the quarterly reports to stockholders.
B) quarterly filings made by a company with the SEC.
C) annual filings made by a company with SEC.
D) filings made by a company with SEC when a company changes auditors.

Question 6

Which of the following is not considered part of GAAP?

A) Statements of Financial Accounting Standards (SFAS)
B) International Accounting Standards (IAS)
C) Accounting Research Bulletins (ARB).
D) Accounting Principles Board Opinions (APB).

Question 7

Which of the following statements is incorrect?

A) Under GAAP, statements are prepared using accrual accounting.
B) Under GAAP, all assets are marked to market each accounting period.
C) Under GAAP, it is necessary to make certain estimates.
D) Annual statements submitted to the SEC (10-K) must be prepared using GAAP.

Question 8

The two primary qualities of accounting information to make it useful for decision making are:

A) reliability and comparability.
B) relevance and reliability.
C) materiality and comparability.
D) full disclosure and relevance.

Question 9

Which of the following is not considered a monitoring mechanism?

A) The Securities and Exchange Commission (SEC)
B) Top level management
C) The board of director's audit committee
D) The external auditors

Question 10

Which of the following statements about directors of a company is true?

A) Directors are elected by management of a company.
B) Directors only get paid if the company increases its profitability that year.
C) Directors are shareholders' representatives.
D) All directors of a company are senior managers in that company.

Question 11

If a company fails to record a material amount of depreciation in a previous year, this is considered:

A) a change in accounting principle.
B) an unusual item.
C) an accounting error.
D) a change in estimate.

Question 12

Which of the following would affect the comparison of financial statements across two different firms?
I) Different accounting principles
II) Different sizes of the companies
III) Different reporting periods
IV) Different industries

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

Question 13

Audit risk represents a danger to users of audited financial statements. The following are attributes pointing to potential areas of vulnerability except

A) company in financial distress requiring financing.
B) management dominated by one or more strong-willed individuals.
C) deterioration in liquidity or solvency.
D) company earning high profits consistently over a number of years.

Question 14

Which of the following would affect the comparability of accounting information for a given company from one accounting period to the next?
I) Change in accounting principles
II) Disposition of segment of business
III) Restructuring expenses
IV) Change in auditors

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

Question 15

The management of Finner Company believes that "the statement of cash flows is not a very useful statement" and does not include it with the company's financial statements. As a result the auditor's opinion should be:

A) qualified.
B) unqualified.
C) adverse.
D) disclaimed.

Question 16

When analyzing financial statements it is important to recognize that accounting distortions can arise. Accounting distortions are those things that cause deviations in accounting information from the underlying economics. Which of the following statements is not correct? Accounting distortions:

A) can arise as management may deliberately manipulate financial statements.
B) arise often through application of (correct) accounting principles.
C) can affect the quality of earnings.
D) arise if the stock market is not efficient.

Question 17

Which would be issued by auditors where there is a history of significant losses coupled with uncertain prospects?

A) An "except for" qualification
B) An adverse opinion
C) A disclaimer of opinion
D) An audit warning

Question 18

Byfort Company reports the following in its financial statements:
$$\begin{array} { | l | c | c | } \hline & \underline { 2005 } & \underline { 2006 } \\\hline \text { Accounts Receivable, net } & \$ 34,289 \mathrm {~K} & \$ 29,678 \mathrm {~K} \\\hline \text { Net sales } & \$ 360,007 \mathrm {~K} & \$ 450,000 \mathrm {~K} \\\hline\end{array}$$ *All sales are on credit.

-How much did the company collect in cash from debtors during 2006?

A) $445,389K
B) $454,611K
C) $484,289K
D) $488,900K

Question 19

Which of the following are examples of judgments made in the accounting reporting process?
I) Useful life of machinery
II) Allowance for doubtful accounts
III) Obsolescence of assets
IV) Interest payment on bonds

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

Question 20

Which of the following statements about accruals and cash flows is false?

A) Company value can be determined by using accrual accounting numbers.
B) Accrual accounting numbers are subject to accounting distortions.
C) Cash flows are more reliable than accruals.
D) Cash flows cannot be manipulated.

Question 21

To determine a company's sustainable earning power, an analyst needs to first determine the recurring component of the current period's accounting income by excluding nonrecurring components of accounting income. Such adjusted earnings are often referred to as:

A) core earnings.
B) permanent earnings.
C) basic earnings.
D) operating earnings.

Question 22

Accounting income consists of all the following components except:

A) permanent component.
B) transitory component.
C) value irrelevant component.
D) temporary component.

Question 23

Economic income includes:

A) recurring components only.
B) nonrecurring components only.
C) both recurring and nonrecurring components.
D) neither recurring nor nonrecurring components.

Question 24

For a going concern, company value can be expressed by:

A) dividing permanent income by the cost of capital.
B) multiplying permanent income by the cost of capital.
C) dividing permanent income by the market value per share.
D) multiplying permanent income by the market value per share.

Question 25

Which of the following is a change in an accounting estimate?
I) A change from straight line depreciation to an accelerated depreciation method.
II) A change in estimated salvage value of depreciable asset.
III) A change in estimated useful life of an asset.
IV) Recording depreciation for the first time on machinery purchased five years ago.

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

Question 26

Which of the following is incorrect? When using the 10-Q, the analyst should be aware that the usefulness of the quarterly financial statements might be affected by:

A) seasonality.
B) adjustments made in the final quarter of the year.
C) the use of cash accounting.
D) the increased use of estimates.

Question 27

Which of the following are changes in accounting principle?
I) A change from LIFO to FIFO.
II) A change in estimated salvage value of depreciable asset.
III) A change from an accelerated depreciation method to straight line depreciation.
IV) Recording depreciation for the first time on machinery purchased five years ago.

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

Question 28

Economic income measures change in:

A) asset value.
B) liability value.
C) shareholder value.
D) net cash flows.

Question 29

The primary responsibility for fair and accurate financial reporting rests with the:

A) board of directors.
B) SEC.
C) management.
D) auditors.

Question 30

Which one of the following is not an example of a red flag, used to evaluate earnings quality?

A) Qualified audit report
B) Net income this year is higher then net income last year
C) Poor financial performance
D) Frequent or unexplained changes in accounting policies

Question 31

SFAS prescribes that information about the level of inputs used for determining fair values must be reported in the:

A) balance sheet.
B) director's letter.
C) footnotes.
D) MD&A.

Question 32

Which of the following is not a source of industry information?

A) SEC manuals
B) Standard and Poor's
C) Trade journals
D) Robert Morris Associates

Question 33

SFAS 157 defines fair value as the:

A) market price.
B) exchange price.
C) net asset value.
D) real value.

Question 34

Which of the following information would not be filed with the SEC by a publicly traded company?

A) 10-K report
B) Prospectus
C) Proxy statement
D) Tax return

Question 35

The matching principle requires that:

A) revenues earned and expenses incurred in generating those revenues should be reported in the same income statement.
B) non-operating gains and losses should be netted against each other.
C) a proportion of each dollar collected will be assumed to be a recovery of cost.
D) assets will be matched to the liabilities incurred to purchase them.

Question 36

Voluntary disclosure by managers is becoming an increasingly important source of information. Which of the following is least likely to be a reason for this increased disclosure?

A) Protection under Safe Harbor Rules.
B) To manage investors' expectations.
C) To signal information to investors.
D) To respond to increased demands by labor unions.

Question 37

All of the following are basic approaches to valuation except:

A) market approach.
B) asset approach.
C) income approach.
D) cost approach.

Question 38

Accounting Standards are best described as:

A) the result of a political process among groups with diverse interests.
B) presentation standards mandated by the Securities and Exchange Commission.
C) the state-of-the-art presentation of the science of accounting.
D) measuring the quality of safeguarding assets.

Question 39

If a company changes auditors, it is required to file the following with the SEC:

A) 10-K
B) 10-Q
C) 8-K
D) S-1

Question 40

The two secondary qualities of accounting information to make it useful for decision making are:

A) consistency and comparability.
B) relevance and reliability.
C) materiality and comparability.
D) full disclosure and relevance.

Question 41

The auditor provides "reasonable", as opposed to "absolute" assurance that the financial statements provide no material misstatement.

Question 42

Under GAAP accounting, a company has the choice of using cash or accrual accounting in preparing its financial statements.

Question 43

Income smoothing is a form of earnings management.

Question 44

Accounting distortions arise from the nature of accrual accounting.

Question 45

By using earnings management, managers always try to increase income.

Question 46

The development of the financial statements is management's responsibility and the auditor is not concerned with the process of development.

Question 47

GAAP stands for General American Accounting Principles, and must be adhered to by publicly traded companies when preparing their financial statements.

Question 48

Accounting standards issued by the SEC are applicable to all US companies being audited.

Question 49

Under accrual accounting, a company will recognize expenses as they are paid.

Question 50

Audits are designed and implemented with the objective of detecting fraud.

Question 51

Accrual income is a better predictor of future cash flows than current cash flows.

Question 52

The "big bath" strategy is often used in conjunction with an income-increasing strategy for other years.

Question 53

Under cash accounting, a company must recognize revenues in financial statements when the revenues are earned or realized.

Question 54

Primary responsibility for fair and accurate financial statements rests with the auditors.

Question 55

Accounting standards are set by the American Institute of Certified Public Accountants (AICPA).

Question 56

Net income is usually higher than free cash flows.

Question 57

FASB stands for Financial Accounting Service Bureau, and is a sub-division of the Securities and Exchange Commission (SEC).

Question 58

Accounting information is "material" if its omission would cause a reasonable person to make a different decision if the information was included.

Question 59

The Securities and Exchange Commission (SEC) has the power to issue accounting standards, but generally defers this responsibility to the Financial Accounting Standards Board (FASB).

Question 60

Income shifting is not one of the earnings management mechanics.

Question 61

Accrual accounting overcomes both the timing and the matching problems that are inherent in cash accounting.

Question 62

Problem One: Motivation to Manipulate Financial Results
There are many ways in which the management of a company can manage the reported earnings. Give three reasons why management may want to manage earnings being sure to explain your answer in full.

Question 63

Accounting or reported income is same as economic income.

Question 64

Problem Two: Earnings Management
Earnings management can be defined as the "purposeful intervention by management in the earnings process, usually to satisfy selfish objectives" (Schipper, 1989).
Earnings management techniques can be separated into those that are "cosmetic" (without cash flow consequences) and those that are "real" (with cash flow consequences).
The management of a company wishes to increase earnings this period.
List three "cosmetic" and three "real" techniques that can be used to achieve this objective and explain why they will achieve the objective.

Question 65

Problem Five: Balance Sheet Analysis of Earnings Quality
The relevance of reported asset values is linked (with few exceptions like cash, held-to-maturity investments and land) with their ultimate recognition as reported expenses. Provisions and liability values on the balance sheet may also affect earnings quality. For each of the following give an example and explain its impact upon cumulative earnings.
a. An overstated asset
b. An understated asset
c. An overstated liability or provision
d. An understated liability or provision

Question 66

Accounting income attempts to capture elements of both permanent income and economic income, but with measurement error.

Question 67

Problem Six: Fair Value Accounting
ABC Co. starts its business raising $110,000 in cash; $60,000 from issuing equity and $50,000 from issuing 6% bonds at par. ABC used the whole amount of cash to buy a building, which it rents out for $10,000 per year. Given below is the opening balance sheet of ABC Co. for the first year of operations.
At the end of Year 1, the building is valued at $150,000. Also, the market value of bonds has fallen to $49,000. Assume the useful life of the building is 30 years and its salvage value is $50,000 at the end of that period. The rental income is received on the last day of the year. Interest on bonds is also paid on this day.
Prepare the year-end balance sheet and income statement of ABC Co. based on Fair value. Compare the historical and fair values at year-end.

Question 68

Operating earnings includes all revenue and expense components that pertain to the company's operating business, regardless of whether they are recurring or nonrecurring.

Question 69

Under the fair value model, income is determined by matching costs to recognized revenues, which have to be realized and earned.

Question 70

Problem Three: Identifying red flags
One step in assessing the quality of earnings is to look for red flags. An example of a red flag is a significant increase in accounts receivable without commensurate growth in sales (that is, accounts receivable turnover decreases). List five other red flags an astute analyst might look for. Also, provide the reason for it being a red flag, and identify where the analyst might find this information.

Question 71

Problem Four: Discretionary Expenditures
Discretionary expenditures are outlays that management can vary across periods to conserve resources and/or manage earnings. Give three examples and explain their potential impact on earnings quality when analyzing a company.

Question 72

FASB has recognized the conceptual superiority of the historical value concept and has, in principle, decided to eventually move to a model where all asset and liability values are recorded at fair value.

Question 73

Operating income is often referred to as net operating profit before tax.

Question 74

The fair value of an asset is the hypothetical price at which a business can sell the asset (exit price).