Question 1

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

Accepted Answer

Serving as an investment banker for a company for which the analyst is providing research coverage is a conflict of interest and violates ethical guidelines. Therefore, it is not a function of a financial analyst. Providing buy and sell recommendations and generating forecasts of company earnings are important functions of financial analysts.

Question 2

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.

Accepted Answer

The answer of Recent accounting scandals suggest the need for...

Question 3

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.

Accepted Answer

The answer of The term "earnings quality" refers to the...

Question 4

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.

Accepted Answer

The answer of Research has shown that numerous companies manage...

Question 5

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.

Accepted Answer

The answer of One of the five techniques of earnings...

Question 6

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

Accepted Answer

The tax effect of debt should be included in the calculation of the weighted-average cost of capital. This is because interest paid on debts is tax-deductible, which reduces the after-tax cost of debt. Therefore, to accurately calculate the cost of capital, the tax effect of debt should be considered. The tax effects of preferred stock and common stock dividends are not relevant to the calculation of the weighted-average cost of capital. Taxes can also affect the cost of equity, but this is typically accounted for by using a higher discount rate to adjust for the higher risk associated with equity financing.

Question 7

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.

Accepted Answer

The answer of The Securities and Exchange Commission (SEC) has...

Question 8

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.

Accepted Answer

The answer of You are auditing a company whose management...

Question 9

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

Accepted Answer

If a company's capital structure is so large that new common stock must be issued at different prices, the firm may have two weighted-average costs of capital. One for its existing capital structure and another for the new common stock issuance.

Question 10

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

Accepted Answer

A cookie jar reserve involves overestimating expenses in one period to create reserves that can be used to boost profits in future periods.

Question 11

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

Accepted Answer

The practice of even out the amount of reported earnings by carefully timing the recognition of revenues and expenses is called income smoothing.

Question 12

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.

Accepted Answer

The answer of Recent accounting scandals have raised concerns over...

Question 13

Which of the following is true?

Accepted Answer

Common equity can be raised through two primary sources: issuing new shares of common stock and using retained earnings. Choice A is incorrect because common equity can also be raised through retained earnings. Choice B is incorrect because there is an opportunity cost associated with using retained earnings as common equity, as those funds could be used for other purposes such as paying dividends or investing in new projects. Choice C is incorrect because issuing new shares of common stock is not a regular practice for most large mature firms, as it can dilute existing shareholders' ownership and lead to a drop in stock price.

Question 14

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.

Accepted Answer

The answer of The following summarized information is available for...

Question 15

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.

Accepted Answer

The answer of Internal earnings targets represent an important tool...

Question 16

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.

Accepted Answer

The answer of The following summarized information is available for...

Question 17

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

Accepted Answer

A pro forma earnings number is not in total conformity with GAAP, as it often excludes certain expenses or includes one-time gains. It is not necessarily a forecast of future earnings, but rather a presentation of earnings under a different set of assumptions or adjustments. Reporting pro forma earnings is not illegal, but companies must disclose the differences between pro forma earnings and GAAP earnings. Therefore, the best choice is D, as it accurately describes a pro forma earnings number as regular GAAP earnings with certain exclusions.

Question 18

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

Accepted Answer

The answer of WM is a waste disposal company. Explain...

Question 19

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".

Accepted Answer

The answer of Several catastrophic accounting failures have occurred over...

Question 20

Which of the following is incorrect?

Accepted Answer

This statement is incorrect. Firms are not required to pay dividends on their common stock issues. The decision to pay dividends is made by the board of directors and can be affected by a variety of factors, including the company's financial performance and investment opportunities. The ease with which common shareholders can assume control of the firm is not directly related to the decision to pay dividends.

Quiz 6: Earnings Management