Podcast
Questions and Answers
On a spectrum for assessing financial reporting quality, which of the following represents the highest quality?
On a spectrum for assessing financial reporting quality, which of the following represents the highest quality?
- Reporting is compliant with GAAP and decision useful but earnings are not sustainable. (correct)
- Reporting is not compliant with GAAP but the numbers presented reflect the company’s actual activities.
- Reporting is compliant with GAAP but reporting choices and estimates are biased.
Which of the following is least likely one of the combinations of the quality of financial reporting and quality of reported earnings along the spectrum of financial report quality?
Which of the following is least likely one of the combinations of the quality of financial reporting and quality of reported earnings along the spectrum of financial report quality?
- Reporting is not compliant and includes numbers that are fictitious or fraudulent.
- Reporting is not compliant with GAAP, although reported earnings are sustainable and adequate. (correct)
- Reporting is compliant with GAAP, but the amount of earnings is actively managed to smooth earnings.
Compared to a firm that appropriately expenses recurring maintenance costs, a firm that capitalizes these costs will report greater cash flow from:
Compared to a firm that appropriately expenses recurring maintenance costs, a firm that capitalizes these costs will report greater cash flow from:
- operating activities. (correct)
- financing activities.
- investing activities.
An analyst would most likely suspect that the quality of a company's earnings is deteriorating if the company:
An analyst would most likely suspect that the quality of a company's earnings is deteriorating if the company:
Which condition that may lead to low-quality financial reporting is Cameron investigating?
Which condition that may lead to low-quality financial reporting is Cameron investigating?
Which of the following accounting warning signs is most likely to indicate manipulation of reported operating cash flows?
Which of the following accounting warning signs is most likely to indicate manipulation of reported operating cash flows?
Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage value of its equipment. This would:
Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage value of its equipment. This would:
If a firm's management wants to use its discretion over accounting choices to increase operating income in the next period, they are most likely to:
If a firm's management wants to use its discretion over accounting choices to increase operating income in the next period, they are most likely to:
Conditions that may cause firms to issue low-quality financial reports are best described as:
Conditions that may cause firms to issue low-quality financial reports are best described as:
Which of the following is least likely to be a motivation for managers to issue financial reports of low quality?
Which of the following is least likely to be a motivation for managers to issue financial reports of low quality?
Which of the following is most accurately described as a characteristic of a firm's quality of earnings?
Which of the following is most accurately described as a characteristic of a firm's quality of earnings?
An IFRS-reporting firm includes in its financial statements a measure that is not defined under IFRS. The firm is least likely required to:
An IFRS-reporting firm includes in its financial statements a measure that is not defined under IFRS. The firm is least likely required to:
With regard to the goal of neutrality in financial reporting, accounting standards related to research costs and litigation losses should be viewed as:
With regard to the goal of neutrality in financial reporting, accounting standards related to research costs and litigation losses should be viewed as:
Management is most likely to be motivated to produce low-quality financial reports when:
Management is most likely to be motivated to produce low-quality financial reports when:
While motivation and opportunity both can lead to low quality of financial reporting, a third important contributing factor is:
While motivation and opportunity both can lead to low quality of financial reporting, a third important contributing factor is:
A mechanism to discipline financial reporting quality for securities that trade in the United States that is not typically imposed on security issuers elsewhere is that:
A mechanism to discipline financial reporting quality for securities that trade in the United States that is not typically imposed on security issuers elsewhere is that:
Which of the following requirements are most likely to create incentives for management to manipulate earnings?
Which of the following requirements are most likely to create incentives for management to manipulate earnings?
Which of the following is one of circumstances that is conducive to issuing low-quality financial reports?
Which of the following is one of circumstances that is conducive to issuing low-quality financial reports?
The quality of a company's reported earnings is low when they:
The quality of a company's reported earnings is low when they:
With regard to a firm's financial reporting quality, an analyst should most likely interpret as a warning sign a focus by management on an increase in the firm's:
With regard to a firm's financial reporting quality, an analyst should most likely interpret as a warning sign a focus by management on an increase in the firm's:
Aggressive accounting choices by management are most likely to:
Aggressive accounting choices by management are most likely to:
A significant increase in days payables above historical levels is most likely associated with:
A significant increase in days payables above historical levels is most likely associated with:
A spectrum for assessing financial reporting quality should consider:
A spectrum for assessing financial reporting quality should consider:
Mechanisms that enforce discipline over financial reporting quality least likely include:
Mechanisms that enforce discipline over financial reporting quality least likely include:
If a firm's financial reports are of low quality, can users of the reports assess the quality of the firm's earnings?
If a firm's financial reports are of low quality, can users of the reports assess the quality of the firm's earnings?
If management is manipulating financial reporting to avoid breaching an interest coverage ratio covenant on the firm's debt, they are most likely to:
If management is manipulating financial reporting to avoid breaching an interest coverage ratio covenant on the firm's debt, they are most likely to:
Which of the following actions is least likely to increase earnings for the current period?
Which of the following actions is least likely to increase earnings for the current period?
In which of the following situations is management most likely to make conservative choices and estimates that reduce the quality of financial reports?
In which of the following situations is management most likely to make conservative choices and estimates that reduce the quality of financial reports?
Flashcards
Highest Quality Financial Reporting
Highest Quality Financial Reporting
Compliant with GAAP, decision-useful, and sustainable earnings.
Capitalizing Costs Effect on CFO
Capitalizing Costs Effect on CFO
When a firm capitalizes costs, it classifies the cash outflow as CFI rather than CFO.
Deteriorating Earnings Quality
Deteriorating Earnings Quality
Boosts reported earnings by increasing estimates of useful lives and salvage values for the company's depreciable assets.
Motivation for low-quality reporting
Motivation for low-quality reporting
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Manipulating Operating Cash Flows
Manipulating Operating Cash Flows
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Overstating Salvage Value Impact
Overstating Salvage Value Impact
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Increasing Operating Income
Increasing Operating Income
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Conditions for low-quality reports
Conditions for low-quality reports
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Weak accounting controls
Weak accounting controls
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Quality of Earnings
Quality of Earnings
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Incentive to manipulate earnings
Incentive to manipulate earnings
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Acceptable accounting treatments
Acceptable accounting treatments
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Low quality earnings
Low quality earnings
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Warning sign of low-quality reporting
Warning sign of low-quality reporting
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Aggressive accounting choices outcomes
Aggressive accounting choices outcomes
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A significant increase in days payables
A significant increase in days payables
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Financial reporting quality
Financial reporting quality
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How management manipulate reports
How management manipulate reports
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Increasing current earnings
Increasing current earnings
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Delay recognition of earnings
Delay recognition of earnings
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Study Notes
Financial Reporting Quality Spectrum
- Highest quality financial reporting is when it complies with GAAP, is decision-useful, but earnings aren't sustainable
- Lowest quality financial reporting happens when GAAP isn't followed, which makes it impossible to judge earnings sustainability and adequacy
- A spectrum of financial reporting quality needs to look at both the quality of the reports and the quality of the earnings
Cash Flow and Cost Capitalization
- A firm that capitalizes recurring maintenance costs will show greater cash flow from financing activities, not from operating or investing activities
- Capitalizing costs classifies the cash outflow as Cash Flow from Investing (CFI) instead of Cash Flow from Operations (CFO), boosting CFO
Deteriorating Earnings Quality
- Declining earnings quality is suspected if a company increases estimated useful lives and salvage values of physical assets
- Boosting reported earnings can be done by increasing estimates of useful lives and salvage values, although it decreases the expenses
- Management commentary that remains static across reporting periods indicates a lack of diligence in financial reporting
Manipulation Warning Signs
- Capitalizing expenses that similar firms expense indicates possible manipulation of operating cash flows
- It increases reported CFO by classifying cash outflows as CFI
- Revenue recognition methods and accounting estimates are not likely to impact on the amount or classification of cash flows
Motivation for low-quality reporting
- Motivation, opportunity, and rationalization can all lead to low quality financial reporting
- Samantha Cameron, CFA, investigates incentives when analyzing financial reporting quality, for low-quality financial reporting
- Meeting analysts' earnings expectations may motivate management to produce low-quality financial reports
- Debt covenants, earnings-based compensation, and avoiding loan covenant breaches are reasons that may cause intentional low-quality reporting
Earnings Management Techniques
- Overstating the salvage value of equipment will overstate earnings, due to reduced depreciation expense
- To increase operating income, the management can increase the assumed residual values of plant and equipment
- Management may make aggressive accounting choices to inflate earnings, revenues, or operating cash flows in the current period, while decreasing them later
Red Flags
- Focus on increasing "pro forma" or non-GAAP earnings is a warning sign of low-quality financial reporting
- A large range of acceptable accounting treatments is conducive to manager bias affecting the quality of financial reporting
Weak Controls
- Weak accounting controls are not a motivation, however can create the opportunity to issue low quality reports
- Unstable organizational structures and deficient internal controls are not conditions for low financial reports
US Regulations
- A signed statement from management on the effectiveness of internal controls is a mechanism to ensure financial reporting quality in the U.S.
IFRS Reporting
- Under IFRS, when a firm includes non-IFRS measures, the firm has to define the measure and explain its relevance and reconcile the differences between the measure and the comparable IFRS measure
Conservative vs. Neutral Reporting
- Standards for expensing research costs and recognizing probable litigation losses are conservative, not neutral
- This reflects earlier recognition of probable losses and later recognition of probable gains
Sustainability
- Sustainability is a key aspect of a firm's quality of earnings
- Relevance and faithful representation are characteristics of a firm's financial reporting quality
Debt covenants
- Debt covenants may incentivize earnings manipulation to meet minimum financial requirements
Payable periods
- A significant increase in payable periods may correspond to untruthful increase in reported earnings
Earnings Manipulation
- Lowering the salvage value of depreciable assets increases expenses and reduces earnings in the present period
- Manipulating financial statements to increase the interest coverage ratio mostly means overstating earnings to maintain a certain level
Assessing earnings with low quality reports
- It's very hard to assess a company's worth if statements are of low quality due to cash flows, earnings, and balance sheets
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