Financial Reporting Quality Flashcards
Which of the following mechanisms is least likely to discourage management’s
manipulation of earnings?
A. Debt covenants.
B. Securities requlators.
C. Class action lawsuits.
A is correct. Because debt covenants typically mandate a certain level of financial performance, they can serve to encourage rather than discourage earnings manipulation.
High earnings quality is most likely to:
A. result in steady earnings growth.
B. improve the ability to predict future earnings.
C. be based on conservative accounting choices.
B is correct. Earnings quality is typically defined in terms of persistence and sustainability. By contrast, earnings may be manipulated to deliver steady growth.
Conservatism in accounting choice may reduce the persistence of earnings as the accounting often reverts to the mean over time.
The best justification for using cash-based accounting is that it:
A. reflects the company’s underlying performance.
B. reflects the economic nature of a company’s transactions.
C. limits management’s discretion in reporting financial results.
C is correct. Cash accounting does not rely on discretionary estimates but rather on actual cash flows. This may be either more or less conservative than accrual-based accounting.
Which of the following is not a measure of aggregate accruals?
A. The change in net operating assets.
B. The difference between operating income and net operating assets.
C. The difference between net income and operating and investing cash flows.
B is correct. A is the balance sheet aggregate accrual measure, while C is the cash flow aggregate accrual measure
Big bath accounting is an earnings management technique
A. whereby income is smoothed over time.
B. that serves the same purpose as hidden reserves.
C. whereby a one-time gain is shown so future years will show decreased net income.
B is correct. Big bath accounting is an earnings management technique whereby a one-time charge is taken against income in order to reduce assets, which results in lower expense in future year. Hidden reserves serve the same purpose of decreasing current income in order to push future income.
