Reading 26: financial reporting quality

Question 1

A firm reports net income of $40 million. The firm’s financial statements disclose in Management’s Discussion and Analysis that $30 million of net income is attributable to a gain on the sale of assets. Based only on this information, for this period, the firm is best described as having high quality of:
financial reporting only.
both earnings and financial reporting.
neither earnings nor financial reporting.

Answer 1

Because a large proportion of net income is due to a one-time gain, this period’s earnings are likely not sustainable and the firm may be said to have low quality of earnings for the period. Clear disclosure of this fact in the financial statements suggests high quality of financial reporting. (LOS 26.a)

Question 2

Which of the following financial reports are considered to be of the lowest quality? Financial reports that reflect:
unsustainable earnings.
biased accounting choices.
departures from accounting principles.

Answer 2

In the spectrum of financial reporting quality, financial reports that depart from generally accepted accounting principles are considered to be of lower quality than those that reflect biased accounting choices. Financial reports that reflect unsustainable earnings, such as one-time gains, can still be of high quality if they state the situation clearly. (LOS 26.b)

Question 3

Financial reporting is most likely to be decision useful when management’s accounting choices are:
neutral.
aggressive.
conservative.

Answer 3

Financial reporting is most likely to be decision useful when accounting choices are neutral. Either aggressive or conservative accounting choices by management may be viewed as biases. (LOS 26.c)

Question 4

Which of the following is least likely to be a motivation to overreport earnings?
Reduce tax obligations.
Meet analyst expectations.
Remain in compliance with bond covenants.

Answer 4

Reducing tax obligations would be a reason to underreport earnings. The other choices are motivations to overreport earnings. (LOS 26.d)

Question 5

With respect to conditions that may lead to low-quality financial reporting, ineffective internal controls are best described as a(n):
motivation.
opportunity.
rationalization.

Answer 5

Ineffective internal controls are a condition that provides an opportunity for low-quality financial reporting. (LOS 26.e)

Question 6

A limitation on the effectiveness of auditing in ensuring financial reporting quality is that:
detecting fraud is not the objective of audits.
public firms are not required to obtain audit opinions.
auditors may only issue a qualified or unqualified opinion but do not explain why.

Answer 6

The objective of audits is to provide reasonable assurance that financial statements are presented fairly. A firm that is engaging in accounting fraud may deceive its auditor. Regulators in most countries require publicly traded firms to obtain independent audits of their financial statements. Auditors may issue a qualified opinion noting certain aspects of financial statements that are inconsistent with accounting principles or an adverse opinion if they find that financial statements are materially misstated and do not conform with GAAP. (LOS 26.f)

Question 7

Under IFRS, a firm that presents a nonstandard financial measure is least likely required to:
provide the same measure for at least two prior periods.
explain the reasons for presenting the nonstandard measure.
reconcile the nonstandard measure to a comparable standard measure.

Answer 7

IFRS require a firm that presents a nonstandard financial measure to reconcile that measure to an IFRS measure and explain why the firm believes the nonstandard measure is relevant to users of the financial statements. Presenting the nonstandard measure for prior periods is not a requirement. (LOS 26.g)

Question 8

For the current period, inappropriate capitalization is most likely to:
overstate revenues.
understate liabilities.
understate expenses.

Answer 8

Management may make inappropriate capitalization decisions to understate expenses by creating balance sheet assets for items that should instead be recognized as expenses in the current period, increasing net income in the current period. Revenues and liabilities are unlikely to be affected by capitalization decisions. (Module 26.2, LOS 26.h)

Question 9

A potential warning sign that a firm is engaging in channel stuffing is an unusual increase in the firm’s:
receivables turnover.
days of sales outstanding.
number of days of payables.

Answer 9

Channel stuffing, which includes activities such as accelerating deliveries to distributors or sending customers unordered merchandise, would likely increase accounts receivable as a percentage of revenues. This would decrease the receivables turnover ratio and increase days of sales outstanding. Payables would not be affected. (Module 26.3, LOS 26.i)