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Learning Module: Financial Reporting Quality

1. In contrast to earnings quality, financial reporting quality most likely pertains to:
A. sustainable earnings.
B. relevant information.
C. adequate return on investment.

2. The information provided by a low-quality financial report will most likely:


A. decrease company value.
B. indicate earnings are not sustainable.
C. impede the assessment of earnings quality.

3. To properly assess a company’s past performance, an analyst requires:


A. high earnings quality.
B. high financial reporting quality.
C. both high earnings quality and high financial reporting quality.

4. Low quality earnings most likely reflect:


A. low-quality financial reporting.
B. company activities which are unsustainable.
C. information that does not faithfully represent company activities.

5. Earnings that result from non-recurring activities most likely indicate:


A. lower-quality earnings.
B. biased accounting choices.
C. lower-quality financial reporting.

6. Which attribute of financial reports would most likely be evaluated as optimal in the
financial reporting spectrum?
A. Conservative accounting choices
B. Sustainable and adequate returns
C. Emphasized pro forma earnings measures

7. Financial reports of the lowest level of quality reflect:


A. fictitious events.
B. biased accounting choices.
C. accounting that is non-compliant with GAAP.

8. When earnings are increased by deferring research and development (R&D)


investments until the next reporting period, this choice is considered:
A. non-compliant accounting.
B. earnings management as a result of a real action.
C. earnings management as a result of an accounting choice.

9. A high-quality financial report may reflect:


A. earnings smoothing.
B. low earnings quality.
Financial Reporting Quality

C. understatement of asset impairment.

10. If a particular accounting choice is considered aggressive in nature, then the financial
performance for the reporting period would most likely:
A. be neutral.
B. exhibit an upward bias.
C. exhibit a downward bias.

11. Conservative accounting choices will most likely lead to:


A. decreased reported earnings in later periods.
B. increased reported earnings in the period under review.
C. increased debt reported on the balance sheet at the end of the current period.

12. Which of the following is most likely to be considered a potential benefit of


accounting conservatism?
A. A reduction in litigation costs
B. Less biased financial reporting
C. An increase in current period reported performance

13. Which of the following statements most likely describes a situation that would
motivate a manager to issue low-quality financial reports? The manager has:
A. increased the market share of products significantly.
B. earned compensation that is linked to stock price performance.
C. brought the company’s profitability to a level higher than competitors.

14. Which of the following concerns would most likely motivate a manager to make
conservative accounting choices?
A. Attention to future career opportunities
B. Debt covenant violation risk in the current period
C. Unexpected strength in the business environment

15. Which of the following conditions best explains why a company’s manager would obtain
legal, accounting, and board level approval prior to issuing low-quality financial
reports?
A. Motivation
B. Opportunity
C. Rationalization

16. A company is experiencing a period of strong financial performance. To increase the


likelihood of exceeding analysts’ earnings forecasts in the next reporting period, the
company would most likely undertake accounting choices for the period under review
that:
A. inflate reported revenue.
B. delay expense recognition.
C. accelerate expense recognition.

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Financial Reporting Quality

17. Which of the following situations represents a motivation, rather than an opportunity,
to issue low-quality financial reports?
A. Poor internal controls
B. Search for a personal bonus
C. Inattentive board of directors

18. Which of the following situations will most likely motivate managers to inflate
reported earnings?
A. Possibility of bond covenant violation
B. Earnings that have exceeded analysts’ forecasts
C. Earnings that have grown from the prior-year period

19. Which of the following best describes an opportunity for management to issue low-
quality financial reports?
A. Ineffective board of directors
B. Pressure to achieve some performance level
C. Corporate concerns about financing in the future

20. An audit opinion of a company’s financial reports is most likely intended to:
A. detect fraud.
B. reveal misstatements.
C. ensure that financial information is presented fairly.

21. If a company uses a non-GAAP financial measure in an SEC filing, then the company
must:
A. give more prominence to the non-GAAP measure if it is used in earnings releases.
B. provide a reconciliation of the non-GAAP measure and equivalent GAAP measure.
C. exclude charges requiring cash settlement from any non-GAAP liquidity measures.

22. A company wishing to increase earnings in the reporting period may choose to:
A. decrease the useful life of depreciable assets.
B. lower estimates of uncollectible accounts receivables.
C. classify a purchase as an expense rather than a capital expenditure.

23. Which technique most likely increases the cash flow provided by operations?
A. Stretching the accounts payable credit period
B. Applying all non-cash discount amortization against interest capitalized
C. Shifting classification of interest paid from financing to operating cash flows

24. Bias in revenue recognition would least likely be suspected if:


A. the firm engages in barter transactions.
B. reported revenue is higher than the previous quarter.
C. revenue is recognized before goods are shipped to customers.

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Financial Reporting Quality

25. Which of the following is an indication that a company may be recognizing revenue
prematurely? Relative to its competitors, the company’s:
A. asset turnover is decreasing.
B. receivables turnover is increasing.
C. days sales outstanding is increasing.

26. Which of the following would most likely signal that a company may be using
aggressive accrual accounting policies to shift current expenses to later periods?
Over the last five-year period, the ratio of cash flow to net income has:
A. increased each year.
B. decreased each year.
C. fluctuated from year to year.

27. An analyst reviewing a firm with a large reported restructuring charge to earnings
should:
A. view expenses reported in prior years as overstated.
B. disregard it because it is solely related to past events.
C. consider making pro forma adjustments to prior years’ earnings.

28. The effectiveness of a debt covenant in disciplining financial reporting quality is most
often limited due to:
A. ineffectiveness of financial triggers.
B. reporting requirements that may not be legally binding.
C. potential for managers to inflate earnings.

29. Which of the following conditions would most likely create opportunities for a
company to issue low-quality financial reports?
A. A company with an audit committee comprised only of independent board members
B. Government cutbacks in the enforcement branch of the financial regulator
C. Accounting standards that provide few choices

30. Overloading distribution channels (“channel stuffing”) would understate:


A. inventories.
B. accounts receivable.
C. revenues.

31. Which of the following is the best example of conservative accounting?


A. Reducing the allowance for bad debt expense below the experienced loss rate.
B. Deferring R&D expenses to a subsequent year.
C. Choosing to depreciate new equipment over the shortest estimate of its useful
life.

32. Which of the following items is a non-GAAP financial measure?


A. Net income after taxes
B. Income from operations

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Financial Reporting Quality

C. EBITDA

33. Conservative, rather than aggressive, accounting is most likely associated with:
A. increased sustainability of earnings.
B. higher current reported performance.
C. recognition of losses once certain.

34. Changing the estimates of the salvage value of capital assets is the least effective
way to manage earnings during the life of an asset for companies whose method of
depreciation is:
A. straight-line.
B. units-of-production.
C. double-declining balance.

35. Which of the following conditions is most likely associated with decreased earnings
quality? Compared with the prior year, the reporting entity’s earnings:
A. decreased slightly in response to the introduction of conservative accounting
policies.
B. were similar in magnitude but included a large gain on the sale of a manufacturing
plant.
C. increased slightly because of a reduction in bad debt expense based on more-
current experiences.

36. Under the indirect method of presenting operating cash flows, which action to alter
the cash flow from operations will be most difficult to detect?
A. Defer payment of a current liability
B. Transact with an unconsolidated special purpose entity
C. Change inventory costing from FIFO to weighted average

37. Which of the following descriptions of financial reporting is considered to be of the


highest quality?
A. Within GAAP but with earnings management
B. Within GAAP but with biased choices
C. Outside GAAP but with conservative choices

38. Which of the following approaches will most likely reveal manipulation of financial
reporting?
A. Using EBITDA to adjust for non-recurring items
B. Evaluating potential warning signals in isolation
C. Comparing a company’s methods and policies to those of its peers

39. Which of the following companies would most likely be considered to have the lowest
financial reporting quality, other things equal?
A. A company that provides high quality, decision-useful information under GAAP but
delays its reports.

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Financial Reporting Quality

B. A company that reports significant profits due to a favorable exchange rate


movement.
C. A company that reports the results from two different segments as a combined
entity.

40. Which of the following is lowest in quality on the spectrum of GAAP conforming
financial reports?
A. Aggressive accounting choices
B. Earnings management
C. Conservative accounting choices

41. An analyst would most likely conduct additional analysis when faced with which of the
following financial presentations?
A. A non-GAAP financial measure that excludes an expense that is likely to recur
B. Reporting a non-GAAP financial measure in an SEC filing
C. A change from LIFO inventory accounting to FIFO

42. Under International Financial Reporting Standards (IFRS), reported operating cash
flows are most likely to be increased by the classification choice made for:
A. impairment losses on fixed assets.
B. dividends paid.
C. interest expense.

43. Which of the following conditions conducive to issuing low-quality financial reports is
most likely a result of poor internal controls?
A. Rationalization
B. Opportunity
C. Motivation

44. Which of the following is most accurate with respect to inherent limitations of
audits?
A. An audit opinion is based on a review of information only prepared by the auditor
B. An audit is based on an exhaustive review of all transactions during a financial
year
C. An expectations gap may exist between the auditor’s role and the public’s
expectation of auditors

45. Which of the following might indicate that a company uses aggressive accounting
choices to increase its reported performance and financial position in the current
period?
A. Increasing the estimated salvage values of PP&E
B. Changing the depreciation method from straight-line to double-declining balance
C. Changing from weighted average to FIFO inventory valuation method in a period
of declining inventory prices and constant inventory quantities

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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). The lowest-quality reports

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Financial Reporting Quality

portray fictitious events, which may misrepresent the company’s performance or


obscure fraudulent misappropriation of the company’s assets.

8. B is correct. Deferring 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, 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 current period under
review. Conservative choices may increase the amount of debt reported on the
balance sheet. They may decrease the revenues, earnings, 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. B is correct. Managers often have incentives to meet or beat market expectations,
particularly if management compensation is linked to increases in share prices or to
reported earnings.

14. C is correct. Managers may be motivated to understate earnings in a period with


unexpected strong performance by delaying revenue recognition or accelerating
expense recognition to increase the probability of exceeding expectations in a
subsequent period (referred to as “banking” some earnings for the next period.)

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, the manager
may ask for other opinions to convince herself or himself that it is okay.

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Financial Reporting Quality

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 reduce financial performance in the current period in order to 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 requires 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

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Financial Reporting Quality

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. 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.

24. 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 insufficient 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.

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. Numerous analytical procedures 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.

28. C is correct. Avoidance of debt covenant violation is a potential motivation for


managers to inflate earnings.

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Financial Reporting Quality

29. B is correct. Cutbacks in the enforcement branch of the financial regulator could lead
to less effective enforcement and oversight of financial issuers, thus creating an
opportunity for low-quality financial reporting.

30. A is correct. “Channel stuffing,” or inducing customers to buy more than usual, will
produce an overstatement of revenues, which may be corrected in future periods if
product is returned. Returned product in future periods would tend to understate
inventories in the current period.

31. C is correct. Depreciating equipment over the shortest estimated period of its useful
life is a conservative accounting choice that reduces earnings in the early years and
increases them in the future, creating a positive trajectory.

32. C is correct. EBITDA is a non-GAAP financial measure. The SEC prohibits the
exclusion of charges or liabilities requiring cash settlement from any non-GAAP
liquidity measures other than EBIT and EBITDA.

33. A is correct. Conservative accounting choices decrease a company’s reported


performance and results in the current period and may increase its reported
performance and financial position in later periods. Therefore, it typically avoids a
sustainability issue.

34. C is correct. The double-declining balance depreciation method applies the rate to
the gross cost of the equipment, so a change in the salvage assumption will have no
effect on earnings until the net book value reaches the estimated salvage value, at
which point the company ceases to take depreciation on the asset.

35. B is correct. The sale of a manufacturing plant is likely a one-time transaction that
will not be sustained in future years. The quality of reported earnings has therefore
decreased from the prior year.

36. B is correct. Unconsolidated special purpose entities are outside of the view of
investors. Transacting with such an entity may initially produce the appearance of a
positive or negative cash flow for the controlling company. Ultimately, this
transaction will most likely be reversed along with the appearance of the initial cash
flow.

37. B is correct. Along the financial reporting quality spectrum, financial reporting that
is within GAAP but has biased choices is considered to be better quality than within-
GAAP financial reporting that is subject to earnings management. Financial reporting
that is non-compliant with GAAP is considered to be even lower quality.

38. C is correct. An investor should compare a company’s policies with those of its peers
to determine whether its approaches match or differ from industry norms; if a

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Financial Reporting Quality

company is the only one in its industry following a particular approach, a red flag is
raised.

39. C is Correct. Combining the results from two segments is an example of biased
reporting, which falls in the middle of the quality spectrum. It is difficult to interpret
the profitability of each segment when their results are combined.

40. B is correct. Earnings management represents deliberate actions to influence


reported earnings and their interpretation. The distinction between earnings
management and biased choices is subtle and, primarily, a matter of intent.

41. A is correct. The exclusion of recurring items from non-GAAP financial measures is
strictly prohibited by the SEC and should raise concerns that additional analysis is
needed.

42. C is correct. IFRS allows the classification of interest expense as either an operating
or a financing cash flow. When interest expense is shown as a financing cash flow,
reported operating cash flows are higher.

43. B is correct. Poor internal controls provide opportunities for errors or fraud to be
incorporated in financial reporting without being detected.

44. C is correct because although audit opinions provide discipline for financial reporting
quality, inherent limitations exist. An “expectations gap” may exist between the
auditor’s role and the public’s expectation of auditors. An audit is not typically
intended to detect fraud; it is intended to provide assurance that the financial
reports are fairly presented.

45. A is correct because increasing the estimated salvage values is an example of a non-
conservative (or aggressive) accounting policy. Depreciation expense is affected by
another set of choices and estimates regarding the salvage value of the assets being
depreciated. A salvage value of zero will always increase depreciation expense under
any method compared with the choice of a non-zero salvage value.

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