Table of Contents
CFA Level 2 – Financial Reporting and Analysis, Session 7 – Reading 27
Evaluating Financial Reporting Quality-LOS f (Practice Questions, Sample Questions)
1. Junior analyst Xander Marshall sends an e-mail to his boss, Janet Jacobs, CFA, suggesting that Peterson Novelties is manipulating its results to artificially inflate profits. He cites four reasons for his conclusion:
The LIFO reserve is declining.
Earnings are much higher in the September quarter than in other quarters.
Many nonoperating and nonrecurring gains are being recorded as revenue.
Much of Peterson’s earnings come from equity investments not reflected on the cash-flow statement.
Jacobs is less concerned about Peterson’s earnings than Marshall is, though she does resolve to check out one of his concerns. Which of Marshall’s observations best supports his conclusion?
A) Nonoperating and nonrecurring gains recorded as revenue.
B) The declining LIFO reserve.
C) Equity investment earnings not reflected on the cash-flow statement
127 our experts are availableright now
Explanation — C: On its own, a declining LIFO reserve is not a sign of fraud. Peterson Novelties could have simply moved a lot of inventory and disclosed the LIFO liquidation in its footnotes. When unusual gains are recorded as revenue they will artificially boost sales growth. Each of the above issues are potential danger signs, but can also be easily explained in a manner beyond reproach. However, earnings from equity investments that do not generate cash flow are of very low quality and warrant further examination
2. Which of the following statements about cash flow is (are) CORRECT?
Statement #1: The cash effects of decreasing accounts payable turnover are unlimited.
Statement #2: The tax benefits from employee stock options can result in a significant source of investing cash flow.
Statement #1 Statement #2
A) Incorrect Incorrect
B) Correct Incorrect
C) Incorrect Correct
Explanation — A: Statement #1 is an incorrect statement. The cash effects of decreasing accounts payable turnover are limited. Suppliers will eventually stop extending credit because of delayed payments. Statement #2 is an incorrect statement. The tax benefits from employee stock options can result in a significant source of operating and financing cash flows. Tax benefits do not affect investing cash flows
3. Charger Corporation offers extended payment terms to its customers. In order to finance its accounts receivable, Charger is considering two alternatives. The first alternative is to borrow against the receivables. The second alternative is to securitize the receivables through a special purpose entity. Which alternative would result in lower operating cash flow and lower financing cash flow?
Lower operating cash flow Lower financing cash flow
A) Securitize Securitize
B) Borrow Securitize
C) Securitize Borrow
Explanation — B: The cash received from borrowing would be reported as a financing inflow. The cash received from securitizing the receivables would be reported as an operating inflow. So, borrowing would result in lower operating cash flow and higher financing cash flow. Securitizing would result in lower financing cash flow and higher operating cash flow
4. Glenmark Blades and Propellers has set up special purpose entities to handle its manufacturing. The company does not consolidate those entities. Glenmark is most likely obeying:
A) neither the spirit of the law nor the letter of the law.
B) the letter of the law but not the spirit of the law.
C) the spirit of the law but not the letter of the law
Explanation — B: Rules regarding special purpose entities (SPE) are quite broad, leaving companies with substantial leeway in interpretation. Separating capital-intensive manufacturing operations from the parent company’s books could give Glenmark a more appealing debt or asset picture. While companies can often opt not to consolidate SPEs, the goal of such entities is not to allow a company to manipulate its financial ratios
5. Samson Therapeutics records all leases as operating leases. The company most likely wanted to reduce:
A) expenses.
B) leverage.
C) inventory
Explanation — B: Finance (capital) leases are recorded on the balance sheet, and by recording all leases as operating leases, the company can reduce its leverage. Lease accounting has no effect on inventory. “Expenses” is not the best answer as operating leases will result in higher expenses in the later years relative to the finance (capital) lease
6. Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage value of its equipment. This would:
A) overstate earnings.
B) overstate liabilities.
C) understate earnings
Explanation — A: Overstating the salvage value reduces depreciation expense, which in turn increases earnings
7. Which of the following measures is least affected by the use of estimates in the financial statement preparation process?
A) Cash flow.
B) Net income.
C) Net equity
Explanation — A: Net income is easily manipulated because of accrual accounting and the many estimates involved. On the other hand, cash flow is unaffected by estimates. However, firms can still manipulate the cash flow statement by misclassifying cash flows, ignoring cash flows, and managing cash flows.
As a result of its relationship to the income statement, net equity (which is generally an accumulation of earnings and losses less dividend payments to shareholders) is directly affected by the estimates used to determine the level of earnings
8. The failure to recognize inventory obsolescence is an example of ___________.
A) Understating expenses.
B) Delaying expenses.
C) Misclassifying expenses
Explanation — A: Inventory must be tested for obsolescence using the lower-of-cost-or-market method. Obsolete inventory must be written down (expensed) in the income statement which results in lower earnings. Thus, failure to recognize obsolescence understates expenses and overstates earnings.
Delaying expenses involves deferring recognition to a future period. Delaying expense is the result of capitalizing a cost instead of immediately recognizing the cost in the income statement. This is not the same as failing to recognize inventory obsolescence.
Investors typically focus more on operating income than nonrecurring and non-operating income. Thus, firms may have an incentive to increase operating income by misclassifying an operating expense as a nonrecurring or non-operating item. Therefore, failure to recognize obsolescence is not an example of misclassification
9. Fero Inc. (Fero) is a successful computer consulting services firm that has an established policy of investing its excess cash in short-term, virtually riskless, and highly liquid money market securities. However, it has recently deviated from this policy by investing in commercial paper and medium-cap domestic equities. As well, Fero entered into a $1.0 million lease with Pasquale Inc. (Pasquale) for some specialized computer equipment on December 28, 2008 that will be shipped at the very start of its next fiscal period on January 1, 2009. In exchange for the lease, Fero agrees to provide consulting services to Pasquale. Which of the following activities is one in which Fero is least likely involved?
A) Managing cash flow.
B) Misclassifying cash flow.
C) Ignoring cash flow
Explanation — A: Fero is ignoring cash flow, most likely misclassifying cash flow, but there is no evidence that Fero is managing cash flow. Firms can misrepresent their cash generating ability by misclassifying investing activities as operating activities and vice versa. For example, under U.S. GAAP, the cash flow statement reconciles the changes in cash and cash equivalents. Cash equivalents include short-term, highly liquid investments. Some firms park cash in longer-term investments such as marketable debt and equity securities. Typically, the acquisition and disposal cash flows from these longer-term investments are reported as investing activities in the cash flow statement.
Noncash investing and financing activities are not reported in the cash flow statement since they do not result in an inflow or outflow of cash. For example, a capital lease is both an investing and financing decision in that the transaction is the equivalent of borrowing the purchase price. However, since no cash is involved, the transaction is not reported (it is ignored) on the cash flow statement throughout the life of the lease
10. With regard to specific measures to analyze in detecting manipulation in the financial reporting process, which of the following statements is the least accurate?
A) A decreasing days’ sales outstanding (DSO) measure may be an indication of lower quality revenue.
B) An increasing days’ inventory on hand (DOH) measure may be indicative of obsolete inventory.
C) Negative nonrecurring or non-operating items may be indicative of misclassifying an operating expense
Explanation — A: Days’ sales outstanding (DSO) measures the number of days it takes to convert receivables into cash and is calculated by dividing the number of days in the period by the accounts receivable turnover ratio. An increasing DSO (decreasing receivables turnover) may be an indication of lower quality revenue; that is, the longer it takes to collect from customers, the more likely the receivables will turn into bad debt.
Days’ inventory on hand (DOH) is equal to the number of days in the period divided by inventory turnover ratio and it measures the number of days it takes to sell inventory. An increasing DOH may be indicative of obsolete inventory.
Analysts should compare changes in the core operating margin over time and look for negative nonrecurring (e.g., restructuring charges, asset impairments, and write-downs) or non-operating items that occurred when the ratio increased. This may be the result of misclassifying an operating expense
