Answers - Reading 12 Evaluating Quality of Financial Reports

Question #1 of 58 Question ID: 1472644 High-quality cash flow is least likely to be characterized by: A) Volatility of operating cash flow being lower than that of the firm’s peers. B) Financing cash flows sufficient to cover capital expenditures, dividends and debt repayments. C) No significant differences between operating cash flow and reported earnings. Explanation High-quality cash flow is characterized by positive OCF that is derived from sustainable sources and is adequate to cover capital expenditures, dividends, and debt repayments. Furthermore, high-quality OCF is characterized by lower volatility than that of the firm's peers. Significant differences between OCF and earnings, or differences that widen over time, can be an indicator of earnings manipulation. (Module 12.4, LOS 12.l) Question #2 of 58 Question ID: 1472650 Which of the following is least likely an indicator of biased measurement in assessing balance sheet quality? A) Company’s investment in debt securities of other companies, carried on the books at market value. B) Overly high assumed discount rate for pension obligations. C) Understatement of impairment charges for property, plant, and equipment. Explanation Carrying investments in debt (or equity) securities at market value enhances balance sheet quality and does not introduce a bias in the estimate. Understatement of impairment charges on PP&E overstates value of PP&E. High discount rate reduces the value of PBO and hence improves the funded position reflected on the balance sheet. (Module 12.5, LOS 12.j) Question #3 of 58 Question ID: 1472629 Which of the following statements about financial disclosures are correct or incorrect? Statement #1: Statement #2: Transitory earnings are usually more important to investors than permanent earnings. Pro-forma earnings are usually prepared in accordance with generally accepted accounting principles. A) Both are incorrect. B) Only statement #2 is incorrect. C) Only statement #1 is incorrect. Explanation Statement #1 is incorrect. Investors are usually more interested in permanent earnings. Statement #2 is incorrect. Pro-forma earnings are not prepared in accordance with generally accepted accounting principles because they may exclude certain transactions. This is why it is important for an analyst to understand the disclosures. (Module 12.2, LOS 12.f) Question #4 of 58 Question ID: 1472633 Hartford Manufacturing Case Scenario Sally Wellington, CFA, analyzes the financial statements of Hartford Manufacturing, a company located in the United States that uses U.S. GAAP. Wellington determines that Hartford's most significant assets are its inventory and long-term assets. Wellington is interested in the financial statement and ratio impact of the accounting methods used by Hartford to account for these assets, especially when compared to the methods used by Hartford's competitors. She gathers the following information to aid in her analysis: Exhibit 1 Selected Financial Information (US$ millions) Year Ended December 31, 20X1 Select Balance Sheet Information Inventory 16,253 Property, plant and equipment, gross 34,221 Accumulated depreciation (12,835) Property, plant and equipment, net 21,836 Total assets 60,038 Total liabilities 40,736 Total equity 19,302 Income Statement Information Revenues 32,396 Cost of goods sold 18,885 Lease expense 590 Other expense 5,911 Depreciation expense 2,336 EBIT 4,674 Interest expense 1,522 Income tax expense (30%) Net income 946 2,206 Based on her knowledge of Hartford's competitors and her review of Hartford's financial statement disclosures and Management's Discussion and Analysis (MD&A), Wellington notes the following: Hartford accounts for its inventory using the LIFO method. All of Hartford's competitors use the FIFO method. As a result of technological advancements, the cost to produce Hartford's inventory has fallen each year for the last five years. Hartford's LIFO reserve was (–)$2,603 in 20X0 and (–)$3,183 in 20X1. Hartford recorded a $520 fixed-asset impairment loss on its December 31, 20X0 income statement. Wellington concluded that this impairment loss increased Hartford's fixed-asset turnover ratio in 20X0, and Hartford's return on assets and net profit margin in 20X1. In 20X1 Hartford changed its depreciation method from the straight-line method to the double-declining balance method and increased the useful lives and salvage values of its fixed assets. The majority of Hartford's lease agreements are accounted for as operating leases. Hartford's largest competitors account for the majority of their leases as capital (finance) leases. Wellington knows that the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have proposed a change in lease accounting that would require the capitalization of all leases, including leases currently classified as operating leases. Using a discount rate of 8% and an average remaining lease term of five years, Wellington determines that the present value of Hartford's operating leases was $2,630 on December 31, 20X1. Which of the following characteristics of Hartford's long-term asset accounting is least likely to be considered a quality of financial reporting problem by Wellington? A) The increase in the useful lives and salvage values of Hartford's fixed assets. B) The classification of the majority of Hartford's leases as operating leases. C) The change from straight-line to double-declining balance depreciation. Explanation Double-declining balance (DDB) depreciation is a more conservative method of depreciation than straight-line because more depreciation expense is reported in the early years under DDB. Therefore, Wellington is not likely to consider Hartford's change from straight-line to double-declining balance depreciation to be a quality of financial reporting problem. Operating leases are a form of off-balance sheet financing that result in an understatement of an entity's liabilities. Wellington will likely consider Hartford's extensive use of operating leases to be a quality of financial reporting problem, especially given that Hartford's largest competitors account for the majority of their leases as capital (finance) leases. The increase in the useful lives and salvage values of Hartford's fixed assets is likely to be considered a quality of financial reporting problem by Wellington because longer useful lives and higher salvage values decrease (understate) depreciation expense. An effort to reduce expense could be a sign that the firm is trying to hide other problems, such as deteriorating core profitability. (Module 12.2, LOS 12.e) Question #5 of 58 Question ID: 1472652 The least valuable source of information about a businesses' risk is: A) Management discussion and analysis section of the annual report. B) Auditor’s report. C) Notes to financial statements. Explanation Because an audit report provides only historical information, such a report's usefulness as an information source is limited. Companies are required to make certain risk related disclosures in the notes to financial statements. Both GAAP and IFRS require companies to disclose risks related to pension benefits, contingent obligations and financial instruments. Ideally, companies should include principal risks that are unique to the business (as opposed to risks faced by most businesses) in their MD&A. (Module 12.5, LOS 12.m) Question #6 of 58 Question ID: 1472637 Mean reversion in earnings means that: A) Extreme low earnings will revert to the mean but extreme high earnings will not. B) Extreme high earnings will revert to the mean but extreme low earnings will not. C) Extreme high as well as low levels of earnings will revert to the mean. Explanation Mean reversion in earnings means that extreme high or low earnings are not sustainable and will mean revert. (Module 12.3, LOS 12.g) Question #7 of 58 Question ID: 1472638 Andre Bursh, is analyzing large retailers and has collected the following information on three companies based on the most recent financial statements: Allied Stores Beta Mart Cash-N-Carry Total Earnings (per share) $2.80 $1.33 $0.75 Cash element $1.90 $0.78 $0.25 Accrual element $0.90 $0.55 $0.50 Bursh notes that all three companies have reported stellar earnings this past year. Bursh is concerned about sustainability of such high earnings. Which company's earnings will revert to its mean fastest? A) Cash-N-Carry. B) Allied Stores. C) Beta Mart. Explanation Cash-N-Carry's earnings is comprised of large proportion of accruals (0.50/0.75 or 67%). Allied's accruals comprise (0.90/2.80) 32% of earnings and Beta's accruals comprise 41% of earnings. (Module 12.3, LOS 12.g) Question #8 of 58 Question ID: 1472621 Pritesh Deshmukh, CFA is analyzing the financial statements of Baza Restaurants Inc. Deshmukh wants to use the Beneish model to evaluate the probability of earnings manipulation. Deshmukh makes the following statements: 1. Depreciation index of less than 1 would indicate that the company is depreciating assets at a lower rate than in prior years. 2. Sales growth index of more than 1 indicates revenue inflation. Which of the statements by Deshmukh are most accurate? A) Statement 1 only. B) None of the statements is accurate. C) Statement 2 only. Explanation Statement 1 is incorrect. Depreciation index of less than 1 indicates that the company is depreciating assets at a higher rate than in prior years. Statement 2 is incorrect. Sales growth index of more than 1 simply implies that the growth in sales is positive. While not a measure of manipulation by itself, growth companies tend to find themselves under pressure to manipulate earnings to meet ongoing expectations. (Module 12.2, LOS 12.d) Question #9 of 58 Question ID: 1472630 High Plains Tubular Company is a leading manufacturer and distributor of quality steel products used in energy, industrial, and automotive applications worldwide. The U.S. steel industry has been challenged by competition from foreign producers located primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs continue to increase. In addition, the U.S. steel mills are technologically inferior to the foreign competitors. Also, the U.S. producers have significant environmental issues that remain unresolved. High Plains is not immune from the problems of the industry and is currently in technical default under its bond covenants. The default is a result of the failure to meet certain coverage and turnover ratios. Earlier this year, High Plains and its bondholders entered into an agreement that will allow High Plains time to become compliant with the covenants. If High Plains is not in compliance by year end, the bondholders can immediately accelerate the maturity date of the bonds. In this case, High Plains would have no choice but to file bankruptcy. High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified opinion from its independent auditor. However, the auditor's opinion included an explanatory paragraph about High Plains' inability to continue as a going concern in the event its bonds remain in technical default. At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO) filed the necessary certifications required by the Securities and Exchange Commission (SEC). To get a better understanding of High Plains' financial situation, it is helpful to review High Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit 2. Exhibit 1: Cash Flow Statement High Plains Tubular Cash Flow Statement Year ended December 31, in thousands Net income Depreciation expense Deferred taxes Receivables Inventory 2008 2007 $158,177 $121,164 34,078 31,295 7,697 11,407 (144,087) (24,852) (79,710) (72,777) Payables 36,107 22,455 $12,262 $88,692 Cash flow from investing ($39,884) ($63,953) Cash flow from financing $82,676 $6,056 Change in cash $55,054 $30,795 Cash flow from operations Exhibit 2: Selected Financial Footnotes 1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to significantly exceed the industry average. Sales are recognized when a firm order is received from the customer, the sales price is fixed and determinable, and collectability is reasonably assured. 2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the first-in, first-out method been used, inventories would have been $152 million and $143 million higher as of December 31, 2008 and 2007, respectively. 3. Effective January 1, 2008, High Plains changed its depreciation method from the double-declining balance method to the straight-line method in order to be more comparable with the accounting practices of other firms within its industry. The change was not retroactively applied and only affects assets that were acquired on or after January 1, 2008. 4. High Plains made the following discretionary expenditures for maintenance and repair of plant and equipment and for advertising and marketing: in millions 2008 2007 2006 Maintenance and repairs $180 $184 $218 Advertising and marketing 94 108 150 5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its accounts receivable, with recourse, to an unrelated entity. All of the receivables were still outstanding at year end. 6. High Plains conducts some of its operations in facilities leased under noncancelable finance (capital) leases. Certain leases include renewal options with provisions for increased lease payments during the renewal term. 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively. Which of the following statements about evaluating High Plains' financial reporting quality is least accurate? A) Higher Plains may have manipulated earnings due to the risk of default. B) High Plains’ extreme revenue growth will likely revert back to normal levels over time. Because of the estimates involved, a higher weighting should be assigned to the C) accrual component of High Plains’ earnings as compared to the cash component. Explanation It appears that High Plains manipulated its earnings upward in 2008 to avoid default under its bond covenants. However, the higher earnings are lower quality as measured by the cash flow accrual ratio. Because of the estimates involved, a lower weighting should be assigned to the accrual component of High Plains' earnings. Extreme earnings (including revenues) tend to revert to normal levels over time (mean reversion). (Module 12.2, LOS 12.f) Question #10 of 58 Question ID: 1472649 Which of the following is least likely an indicator of biased measurement in assessing balance sheet quality? A) Understatement of valuation allowance for deferred tax assets. B) Presence of substantial goodwill on balance sheet. C) Understatement of inventory impairment charges. Explanation Presence of substantial goodwill does not inherently make it biased measurement. Only if the value of goodwill is unjustified (based on market values of the investments), would the measurement be considered biased. Understatement of inventory impairment charges overstates value of inventory. Similarly understatement of valuation allowance for deferred tax assets overstates the value of deferred tax assets. (Module 12.5, LOS 12.j) Question #11 of 58 Question ID: 1472615 High Plains Tubular Company is a leading manufacturer and distributor of quality steel products used in energy, industrial, and automotive applications worldwide. The U.S. steel industry has been challenged by competition from foreign producers located primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs continue to increase. In addition, the U.S. steel mills are technologically inferior to the foreign competitors. Also, the U.S. producers have significant environmental issues that remain unresolved. High Plains is not immune from the problems of the industry and is currently in technical default under its bond covenants. The default is a result of the failure to meet certain coverage and turnover ratios. Earlier this year, High Plains and its bondholders entered into an agreement that will allow High Plains time to become compliant with the covenants. If High Plains is not in compliance by year end, the bondholders can immediately accelerate the maturity date of the bonds. In this case, High Plains would have no choice but to file bankruptcy. High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified opinion from its independent auditor. However, the auditor's opinion included an explanatory paragraph about High Plains' inability to continue as a going concern in the event its bonds remain in technical default. At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO) filed the necessary certifications required by the Securities and Exchange Commission (SEC). To get a better understanding of High Plains' financial situation, it is helpful to review High Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit 2. Exhibit 1: Cash Flow Statement High Plains Tubular Cash Flow Statement Year ended December 31, in thousands Net income Depreciation expense Deferred taxes Receivables Inventory 2008 2007 $158,177 $121,164 34,078 31,295 7,697 11,407 (144,087) (24,852) (79,710) (72,777) Payables 36,107 22,455 $12,262 $88,692 Cash flow from investing ($39,884) ($63,953) Cash flow from financing $82,676 $6,056 Change in cash $55,054 $30,795 Cash flow from operations Exhibit 2: Selected Financial Footnotes 1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to significantly exceed the industry average. Sales are recognized when a firm order is received from the customer, the sales price is fixed and determinable, and collectability is reasonably assured. 2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the first-in, first-out method been used, inventories would have been $152 million and $143 million higher as of December 31, 2008 and 2007, respectively. 3. Effective January 1, 2008, High Plains changed its depreciation method from the double-declining balance method to the straight-line method in order to be more comparable with the accounting practices of other firms within its industry. The change was not retroactively applied and only affects assets that were acquired on or after January 1, 2008. 4. High Plains made the following discretionary expenditures for maintenance and repair of plant and equipment and for advertising and marketing: in millions 2008 2007 2006 Maintenance and repairs $180 $184 $218 Advertising and marketing 94 108 150 5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its accounts receivable, with recourse, to an unrelated entity. All of the receivables were still outstanding at year end. 6. High Plains conducts some of its operations in facilities leased under noncancelable finance (capital) leases. Certain leases include renewal options with provisions for increased lease payments during the renewal term. 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively. What is the most likely effect of High Plains' revenue recognition policy on net income and inventory turnover? A) Only inventory turnover is overstated. B) Net income and inventory turnover are overstated. C) Only net income is overstated. Explanation Revenue should be recognized when earned and payment is assured. High Plains is recognizing revenue as orders are received. Since High Plains still has an obligation to deliver the goods, revenue is not yet earned. By recognizing revenue too soon, net income is overstated and ending inventory is understated. Understated ending inventory would result in an overstated inventory turnover ratio. (Module 12.1, LOS 12.b) Question #12 of 58 Question ID: 1472617 William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection with a potential investment recommendation of their common stocks. He is particularly concerned about the quality of each company's financial results in 2007–2008 and in developing projections for 2009 and 2010 fiscal years. Adams Company has been the largest company in the industry, but Jefferson Inc. has grown more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower domestic revenue growth for both companies. The 10-k reports showed overall sales growth of 6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in overseas business was particularly impressive. According to the company's 10-k report, Jefferson offered a sales incentive to overseas customers. For those customers accepting the special sales discount, Jefferson shipped products to specific warehouses in foreign ports rather than directly to those customers' facilities. In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the impact of overall accruals on earnings quality. He noted that Jefferson had instituted an accounting change in 2008. The economic life for new plant and equipment investments was determined to be five years longer than for previous investments. For Adams, he noted that the higher level of inventories at the end of 2008 might be cause for concern in light of a further slowdown expected in the U.S. economy in 2009. The accompanying table shows financial data for both companies' Form 10-k reports for 2006–2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and related expenses for both companies as well as cash collections and receivables comparisons. Inventory trends relative to sales and the number of days' sales outstanding in inventory were determined for both companies. Expense trends were examined for Adams and Jefferson relative to sales growth and accrual ratios on a balance sheet and cash flow basis were developed as overall measures of earnings quality. Adams Company ($ in thousands) Gross sales Sales discounts, returns, and allowances Net sales Jefferson Inc. 2006 2007 2008 2006 2007 2008 32,031 34,273 36,330 25,625 27,675 30,900 781 836 886 625 675 900 31,250 33,438 35,444 25,000 27,000 30,000 Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500 9,028 9,660 10,240 7,222 7,800 8,200 Depreciation expense 625 669 709 500 515 516 Interest expense 400 428 454 360 366 396 Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388 Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155 Net income 3,501 3,746 3,971 2,668 3,041 3,233 Dividends 3,000 3,180 3,307 2,460 2,760 2,880 501 566 664 208 281 353 150 160 170 120 130 120 250 325 345 200 217 195 15,875 16,758 17,763 12,700 13,000 15,892 6,500 6,850 7,800 5,200 5,200 4,500 8,562 8,991 9,440 6,850 7,057 7,200 31,337 33,084 35,518 25,070 25,604 27,907 7,062 7,880 9,300 6,050 6,100 6,398 337 400 450 270 373 1,525 Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600 Common stock 15,000 15,000 15,000 12,000 12,000 12,000 1,438 2,004 2,668 750 1,031 1,384 31,337 33,084 35,518 25,070 25,604 27,907 % change gross sales 7.0% 6.0% 8.0% 11.7% % change sales 6.0% 6.0% 8.0% 33.3% SG&A expenses Net addition to retained earnings Balance Sheet Cash and equivalents Short-term marketable securities Accounts receivable (net) Inventories PP&E (net of depreciation) Total assets Accounts payable Other current liabilities Retained earnings Total liabilities and shareholders equity discounts and allowances % change net sales 7.0% 6.0% 8.0% 11.1% 7.0% 6.0% 8.0% 17.0% 6.0% 6.0% 8.0% 5.1% 6.0% 6.0% 3.0% 0.2% 6.0% 6.0% 2.0% 22.3% 5.0% 13.8% 0.0% (13.5%) 1.03 1.03 1.03 1.0 1.0 1.1 155 153 164 144 143 106 3.4% 3.5% 3.9% 2.0% 2.4% 10.1% 3.4% 3.5% 3.8% 2.0% 2.0% 4.3% % change cost of goods sold % change in SG&A % change in depreciation expense % change in accounts receivable % change in inventories Revenues % cash collections Days inventory outstanding Balance sheet accrual ratio Cash flow accrual ratio Jones also observed that inventory and cost of goods sold comparisons showed: Jefferson’s inventory levels may be understated and sales overstated to the A) extent of product shipments for the special offer; Adams’s inventory increase may reflect slowing product demand and possible inventory obsolescence. Jefferson’s inventory increase and large increase in cost of goods sold may be B) related to the success of the special offer; Adams’s large increase in inventories suggests possible inventory obsolescence. Jefferson’s inventory decline suggests possible problems in inventory C) management to meet the stronger customer demand from the special offer; Adams’s large inventory increase suggests better inventory management to meet future sales growth. Explanation Jefferson's revenue and inventory levels may be distorted by revenue recognition for new business from the special offer. Although the customers agreed to delay delivery of the products, recognition of these sales prior to customer delivery lowers the quality of these sales and understates inventory. Inventory is understated if the sale is not totally complete. (Module 12.1, LOS 12.b) Question #13 of 58 Question ID: 1472640 Pysha Heavy Metals Ltd. supplies specialized metals to the chip fabrication industry. Selected financial data for Pysha, as well as industry comparables, are shown below: Pysha selected financial data (£ '000s): 20x7 20x8 20x9 Sales 1,169 1,312 1,414 Accounts receivable 58.45 72.16 98.98 20x7 20x8 20x9 DSO 22.6 22.8 22.4 Receivables turnover 16.2 16.0 16.3 Industry average: Note: DSO and receivables turnover are based on year-end receivables. Relative to industry average, for 20x9, Pysha's DSO and Receivables turnover are most likely: Receivables DSO turnover A) Lower higher B) Higher higher C) Higher lower Explanation Pysha's DSO and receivables turnover is calculated as follows: DSO 18.25 20.08 25.55 receivables turnover 20.00 18.18 14.29 For 20x9, industry DSO and receivables turnover are given as 22.4 and 16.3 respectively. Hence Pysha's DSO is higher and receivable turnover is lower than industry average. (Module 12.3, LOS 12.h) Question #14 of 58 Question ID: 1472642 William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection with a potential investment recommendation of their common stocks. He is particularly concerned about the quality of each company's financial results in 2007–2008 and in developing projections for 2009 and 2010 fiscal years. Adams Company has been the largest company in the industry, but Jefferson Inc. has grown more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower domestic revenue growth for both companies. The 10-k reports showed overall sales growth of 6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in overseas business was particularly impressive. According to the company's 10-k report, Jefferson offered a sales incentive to overseas customers. For those customers accepting the special sales discount, Jefferson shipped products to specific warehouses in foreign ports rather than directly to those customers' facilities. In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the impact of overall accruals on earnings quality. He noted that Jefferson had instituted an accounting change in 2008. The economic life for new plant and equipment investments was determined to be five years longer than for previous investments. For Adams, he noted that the higher level of inventories at the end of 2008 might be cause for concern in light of a further slowdown expected in the U.S. economy in 2009. The accompanying table shows financial data for both companies' Form 10-k reports for 2006–2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and related expenses for both companies as well as cash collections and receivables comparisons. Inventory trends relative to sales and the number of days' sales outstanding in inventory were determined for both companies. Expense trends were examined for Adams and Jefferson relative to sales growth and accrual ratios on a balance sheet and cash flow basis were developed as overall measures of earnings quality. Adams Company ($ in thousands) Gross sales Sales discounts, returns, and allowances Net sales Jefferson Inc. 2006 2007 2008 2006 2007 2008 32,031 34,273 36,330 25,625 27,675 30,900 781 836 886 625 675 900 31,250 33,438 35,444 25,000 27,000 30,000 Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500 9,028 9,660 10,240 7,222 7,800 8,200 Depreciation expense 625 669 709 500 515 516 Interest expense 400 428 454 360 366 396 Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388 Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155 Net income 3,501 3,746 3,971 2,668 3,041 3,233 Dividends 3,000 3,180 3,307 2,460 2,760 2,880 501 566 664 208 281 353 150 160 170 120 130 120 250 325 345 200 217 195 15,875 16,758 17,763 12,700 13,000 15,892 6,500 6,850 7,800 5,200 5,200 4,500 8,562 8,991 9,440 6,850 7,057 7,200 31,337 33,084 35,518 25,070 25,604 27,907 7,062 7,880 9,300 6,050 6,100 6,398 337 400 450 270 373 1,525 Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600 Common stock 15,000 15,000 15,000 12,000 12,000 12,000 1,438 2,004 2,668 750 1,031 1,384 31,337 33,084 35,518 25,070 25,604 27,907 % change gross sales 7.0% 6.0% 8.0% 11.7% % change sales 6.0% 6.0% 8.0% 33.3% SG&A expenses Net addition to retained earnings Balance Sheet Cash and equivalents Short-term marketable securities Accounts receivable (net) Inventories PP&E (net of depreciation) Total assets Accounts payable Other current liabilities Retained earnings Total liabilities and shareholders equity discounts and allowances % change net sales 7.0% 6.0% 8.0% 11.1% 7.0% 6.0% 8.0% 17.0% 6.0% 6.0% 8.0% 5.1% 6.0% 6.0% 3.0% 0.2% 6.0% 6.0% 2.0% 22.3% 5.0% 13.8% 0.0% (13.5%) 1.03 1.03 1.03 1.0 1.0 1.1 155 153 164 144 143 106 3.4% 3.5% 3.9% 2.0% 2.4% 10.1% 3.4% 3.5% 3.8% 2.0% 2.0% 4.3% % change cost of goods sold % change in SG&A % change in depreciation expense % change in accounts receivable % change in inventories Revenues % cash collections Days inventory outstanding Balance sheet accrual ratio Cash flow accrual ratio The quality of earnings as measured by cash-flow-based accruals ratios showed: Jefferson’s 2008 accrual ratio exceeded Adams’s ratio for the first time in the A) 2006–2008 period, thus demonstrating significant improvement in earnings quality relative to Adams’s. Jefferson’s 2008 accrual ratio exceeded Adams’s ratio for the first time in the B) 2006–2008 period, indicating a decline in earnings quality compared to previous years and lower earnings quality relative to Adams’s in 2008. C) Jefferson’s higher accruals ratio in 2008 compared to 2007 and relative to Adams’s in 2008 indicates Jefferson’s higher earnings quality. Explanation The lower the ratio, the higher will be the earnings quality. Jefferson's ratio rose sharply in 2008 and exceeded Adams's ratio for the first time in the three years. Thus, Jefferson's earnings quality is lower. (Module 12.3, LOS 12.h) Question #15 of 58 Question ID: 1472607 De Freitas Inc. (De Freitas) is a conglomerate. Its computer division was very profitable in the current year because it launched a successful new lightweight laptop computer. Prices in the automobile division have been rising over the years but it is engaged in a LIFO liquidation in the current year. Which of the following best describes the effect on the long-run earnings of the computer division and the automobile division compared to the most recent year? Computer Automobile division division earnings earnings A) Decrease Decrease B) Decrease Increase C) Increase Decrease Explanation When examining earnings, analysts should be aware that earnings at extreme levels tend to revert back to normal levels over time. This phenomenon is known as mean reversion. For example, capital is attracted to successful projects (i.e. the new laptop) thereby increasing competition and decreasing earnings in the long-run. A LIFO liquidation involves selling more goods than are replaced. Thus, the automobile division penetrated the older, lower cost layers of inventory thereby increasing profit. This higher profitability is not sustainable, however, because the firm will eventually run out of lower priced inventory. In the long-run, the earnings will decrease (to normal levels). (Module 12.1, LOS 12.b) Question #16 of 58 Question ID: 1472597 Which of the following choices is most likely a biased accounting choice to overstate profitability? A) Channeling gains through OCI and losses through income statement. B) Lessor use of sales-type finance lease classification. C) Classifying non-operating expenses as operating. Explanation Lessor use of sales-type finance lease classification results in Lessor recognizing the gross profit at inception of the lease and is a mechanism to overstate profitability. Classifying non-operating expenses as operating and channeling gains through OCI and losses through income statement would understate profitability. (Module 12.1, LOS 12.b) Question #17 of 58 Question ID: 1472600 Which of the following items is least likely to involve the use of subjective measurement estimates by management? A) Use of FIFO (first in-first out) to cost inventories. B) Use of criteria to determine treatment as an extraordinary item. C) Use of straight-line depreciation method to depreciate tangible assets. Explanation The use of criteria to determine treatment as an extraordinary item (i.e. Is the item within management's discretion? Is the event likely to recur in the foreseeable future?) does not involve numerical and subjective estimates per se. It is more a test of qualitative factors to determine the proper classification. Contrast this to FIFO, which is clearly a numerical estimate since an alternative of using LIFO (last in-first out) is possible and this will result in a different reported amount than FIFO. The same argument can be made for the use of the straight-line method since an alternative of using the declining-balance method is possible to depreciate tangible assets. (Module 12.1, LOS 12.b) Question #18 of 58 Question ID: 1472634 Complete the following sentence. When earnings are relatively free of accruals, mean reversion will occur __________. A) relatively slower than usual. B) relatively faster than usual. C) at the same rate as usual. Explanation Earnings consist of cash flow and accruals and there is an inverse relationship between accruals and cash flow. When earnings are relatively free of accruals, mean reversion will occur at a slower rate. The opposite is true when earnings are largely comprised of accruals. (Module 12.3, LOS 12.g) Question #19 of 58 Question ID: 1472651 Asma Pharma has made several strategic investments in other pharmaceutical companies. In each instance, Asma has kept its stake just below 50% so it can account for the investment using the equity method of consolidation. Asma's balance sheet quality can be most accurately characterized as: A) High-quality due to compliance with local GAAP. B) Low-quality due to lack of completeness. C) Low-quality due to bias in measurement. Explanation One-line consolidation under the equity method obscures the components of balance sheet and artificially boosts certain profitability ratios (e.g., return on assets or profit margin). This reduces the completeness and quality of the firm's balance sheet. Compliance with GAAP is a necessary but not sufficient condition for evaluating quality of financial statements. Equity method of accounting does not by itself lead to measurement bias. (Module 12.5, LOS 12.k) Question #20 of 58 Question ID: 1472627 Classification of non-operating income as operating would lead to stated earnings that are likely to be: A) compliant with GAAP but not sustainable. B) compliant with GAAP and sustainable. C) non-compliant with GAAP. Explanation Non-operating income is less likely to recur and hence the earnings that include such misclassified non-operating income would be considered non-sustainable. The misclassification need not always be GAAP non-compliant. (Module 12.2, LOS 12.f) Question #21 of 58 Question ID: 1472639 Pysha Heavy Metals Ltd. supplies specialized metals to the chip fabrication industry. Selected financial data for Pysha, as well as industry comparables, are shown below: Pysha selected financial data (£ '000s): 20x7 20x8 20x9 Sales 1,169 1,312 1,414 Accounts receivable 58.45 72.16 98.98 20x7 20x8 20x9 DSO 22.6 22.8 22.4 Receivables turnover 16.2 16.0 16.3 Industry average: Based on the trend in revenues and receivables, it can be most accurately concluded that: A) Pysha’s revenues are growing at a faster rate than its receivables. B) Pysha’s revenues are growing at a slower rate than its receivables C) The revenue growth rate divided by receivables growth rate is increasing over time. Explanation Pysha's revenue growth rate is lagging the receivables growth rate. 20x7 20x8 20x9 Revenue growth - 12.23% 7.77% Receivable growth - 23.46% 37.17% 52.15% 20.92% Ratio (Module 12.3, LOS 12.h) Question #22 of 58 Question ID: 1472599 Errors that affect multiple financial statement elements are most likely to arise from: A) classification issues. B) compound issues. C) measurement and timing issues. Explanation Measurement and timing issues typically affect multiple financial statement elements while classification issues typically affects categorization of a specific element in a financial statement. (Module 12.1, LOS 12.b) Question #23 of 58 Question ID: 1472604 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 Overstating the salvage value reduces depreciation expense, which in turn increases earnings. (Module 12.1, LOS 12.b) Question #24 of 58 Question ID: 1472611 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 cashflow 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) The declining LIFO reserve. B) Equity investment earnings not reflected on the cash-flow statement. C) Nonoperating and nonrecurring gains recorded as revenue. Explanation 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. (Module 12.1, LOS 12.b) Question #25 of 58 Question ID: 1472624 Complete the following sentence. The cash component of income is ___________ than the accrual component. A) less persistent. B) the same persistence. C) more persistent. Explanation The accrual component of income (accruals) is less persistent than the cash component. By persistent we mean the income is sustainable; that is, a dollar of earnings today implies a dollar of earnings in future periods. Lower persistency is partially due to the estimates involved with accrual accounting. (Module 12.2, LOS 12.f) Question #26 of 58 Question ID: 1472628 A manufacturing firm purchases equipment for use in its operations. With regard to recording the purchase using the cash basis versus the accrual basis of accounting, which of the following statements is most appropriate? A) B) C) With the cash basis, revenues and expenses relating to the equipment are generally recognized in different periods. With the accrual basis, the cost of the equipment is allocated to the cash flow statements over the asset’s life. With the cash basis, revenues and expenses relating to the equipment are generally recognized in the same period. Explanation With the cash basis of accounting, revenues are recognized when cash is collected and expenses are recognized when cash is paid. Therefore, the cash flows may occur in different periods than when the revenues are actually earned or when the expenses are actually incurred. For example, the purchase of equipment used in a firm's manufacturing operation may result in an immediate cash outflow but the equipment generates revenues over its useful life. In this case, the revenues and expense are reported in different periods. With the accrual basis of accounting, revenues are recognized when earned and expenses are recognized when incurred, regardless of the timing of the cash flows. With the equipment purchase, the cost of the equipment will be allocated to the income statement (not cash flow statement) over the asset's life and at the same time, matched with the revenues generated. (Module 12.2, LOS 12.f) Question #27 of 58 Question ID: 1472641 High Plains Tubular Company is a leading manufacturer and distributor of quality steel products used in energy, industrial, and automotive applications worldwide. The U.S. steel industry has been challenged by competition from foreign producers located primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs continue to increase. In addition, the U.S. steel mills are technologically inferior to the foreign competitors. Also, the U.S. producers have significant environmental issues that remain unresolved. High Plains is not immune from the problems of the industry and is currently in technical default under its bond covenants. The default is a result of the failure to meet certain coverage and turnover ratios. Earlier this year, High Plains and its bondholders entered into an agreement that will allow High Plains time to become compliant with the covenants. If High Plains is not in compliance by year end, the bondholders can immediately accelerate the maturity date of the bonds. In this case, High Plains would have no choice but to file bankruptcy. High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified opinion from its independent auditor. However, the auditor's opinion included an explanatory paragraph about High Plains' inability to continue as a going concern in the event its bonds remain in technical default. At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO) filed the necessary certifications required by the Securities and Exchange Commission (SEC). To get a better understanding of High Plains' financial situation, it is helpful to review High Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit 2. Exhibit 1: Cash Flow Statement High Plains Tubular Cash Flow Statement Year ended December 31, in thousands Net income Depreciation expense Deferred taxes Receivables Inventory 2008 2007 $158,177 $121,164 34,078 31,295 7,697 11,407 (144,087) (24,852) (79,710) (72,777) Payables 36,107 22,455 $12,262 $88,692 Cash flow from investing ($39,884) ($63,953) Cash flow from financing $82,676 $6,056 Change in cash $55,054 $30,795 Cash flow from operations Exhibit 2: Selected Financial Footnotes 1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to significantly exceed the industry average. Sales are recognized when a firm order is received from the customer, the sales price is fixed and determinable, and collectability is reasonably assured. 2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the first-in, first-out method been used, inventories would have been $152 million and $143 million higher as of December 31, 2008 and 2007, respectively. 3. Effective January 1, 2008, High Plains changed its depreciation method from the double-declining balance method to the straight-line method in order to be more comparable with the accounting practices of other firms within its industry. The change was not retroactively applied and only affects assets that were acquired on or after January 1, 2008. 4. High Plains made the following discretionary expenditures for maintenance and repair of plant and equipment and for advertising and marketing: in millions 2008 2007 2006 Maintenance and repairs $180 $184 $218 Advertising and marketing 94 108 150 5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its accounts receivable, with recourse, to an unrelated entity. All of the receivables were still outstanding at year end. 6. High Plains conducts some of its operations in facilities leased under noncancelable finance (capital) leases. Certain leases include renewal options with provisions for increased lease payments during the renewal term. 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively. Does High Plains' accounting treatment of its finance (capital) leases and receivable sale lower its earnings quality? A) The treatment of the receivables sale lowers earnings quality. B) The treatment of finance (capital) leases lowers earnings quality. C) Both treatments lower earnings quality. Explanation A finance (capital) lease is reported on the balance sheet as an asset and as a liability. In the income statement, the leased asset is depreciated and interest expense is recognized on the liability. Thus, capitalizing a lease enhances earnings quality. An operating lease lowers earnings quality. The receivable sale, with recourse, lowers earnings quality. The sale is treated as a collection thereby increasing operating cash flow. However, High Plains is still responsible to the buyer in the event the receivables are not ultimately collected. Thus, the receivable sale is a collateralized borrowing arrangement that remains off-balance-sheet. (Module 12.3, LOS 12.h) Question #28 of 58 Question ID: 1472605 The failure to recognize inventory obsolescence is an example of ___________. A) Misclassifying expenses. B) Understating expenses. C) Delaying expenses. Explanation 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. (Module 12.1, LOS 12.b) Question #29 of 58 Question ID: 1472648 High Plains Tubular Company is a leading manufacturer and distributor of quality steel products used in energy, industrial, and automotive applications worldwide. The U.S. steel industry has been challenged by competition from foreign producers located primarily in Asia. All of the U.S. producers are experiencing declining margins as labor costs continue to increase. In addition, the U.S. steel mills are technologically inferior to the foreign competitors. Also, the U.S. producers have significant environmental issues that remain unresolved. High Plains is not immune from the problems of the industry and is currently in technical default under its bond covenants. The default is a result of the failure to meet certain coverage and turnover ratios. Earlier this year, High Plains and its bondholders entered into an agreement that will allow High Plains time to become compliant with the covenants. If High Plains is not in compliance by year end, the bondholders can immediately accelerate the maturity date of the bonds. In this case, High Plains would have no choice but to file bankruptcy. High Plains follows U.S. GAAP. For the year ended 2008, High Plains received an unqualified opinion from its independent auditor. However, the auditor's opinion included an explanatory paragraph about High Plains' inability to continue as a going concern in the event its bonds remain in technical default. At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO) filed the necessary certifications required by the Securities and Exchange Commission (SEC). To get a better understanding of High Plains' financial situation, it is helpful to review High Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit 2. Exhibit 1: Cash Flow Statement High Plains Tubular Cash Flow Statement Year ended December 31, in thousands 2008 2007 Net income $158,177 $121,164 Depreciation expense 34,078 31,295 Deferred taxes 7,697 11,407 Receivables (144,087) (24,852) Inventory (79,710) (72,777) Payables 36,107 22,455 Cash flow from operations $12,262 $88,692 Cash flow from investing ($39,884) ($63,953) Cash flow from financing $82,676 $6,056 Change in cash $55,054 $30,795 Exhibit 2: Selected Financial Footnotes 1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to significantly exceed the industry average. Sales are recognized when a firm order is received from the customer, the sales price is fixed and determinable, and collectability is reasonably assured. 2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the first-in, first-out method been used, inventories would have been $152 million and $143 million higher as of December 31, 2008 and 2007, respectively. 3. Effective January 1, 2008, High Plains changed its depreciation method from the double-declining balance method to the straight-line method in order to be more comparable with the accounting practices of other firms within its industry. The change was not retroactively applied and only affects assets that were acquired on or after January 1, 2008. 4. High Plains made the following discretionary expenditures for maintenance and repair of plant and equipment and for advertising and marketing: in millions 2008 2007 2006 Maintenance and repairs $180 $184 $218 Advertising and marketing 94 108 150 5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its accounts receivable, with recourse, to an unrelated entity. All of the receivables were still outstanding at year end. 6. High Plains conducts some of its operations in facilities leased under noncancelable finance (capital) leases. Certain leases include renewal options with provisions for increased lease payments during the renewal term. 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively. As compared to the year ended 2007, High Plains' cash flow accrual ratio for the year ended 2008 is: A) higher. B) lower. C) the same. Explanation The cash flow accrual ratio increased during 2008 from 15% to 19%. in thousands 2008 2007 $158,177 $121,164 12,262 88,692 (39,884) (63,953) = Accruals $185,799 $96,425 ÷ Net operating assets $977,890 $642,830 19% 15% Net income − Cash from operations − Cash from investing = Cash flow accrual ratio (Module 12.4, LOS 12.i) Question #30 of 58 Question ID: 1472613 Which of the following statements about operating income and operating cash flow are correct or incorrect? If operating income is growing faster than operating cash flow over the Statement #1: long-term, the firm may be recognizing revenue too soon or delaying the recognition of expense. Statement #2: Operating cash flow exceeding operating income is sustainable over the long-term. A) Both are incorrect. B) Only one is correct. C) Both are correct. Explanation Statement #1 is correct. If operating income and operating cash flow are growing at different rates over the long-term, the firm may be engaging in earnings manipulation. Statement #2 is incorrect. Over the long-term, operating cash flow will eventually decline without the support of operating income. (Module 12.1, LOS 12.b) Question #31 of 58 Question ID: 1472623 Consider the following statements: Statement 1: Statement 2: Compared to the cash basis of accounting, the accrual basis of accounting provides more timely information about future cash flows. Compared to the cash basis of accounting, the accrual basis requires more use of discretion than the cash basis. Are these statements CORRECT? A) Yes. No, because it is actually the cash basis of accounting that results in more B) difficulty in properly assigning revenues and expenses to the appropriate periods. C) No, because it is actually the cash basis of accounting that provides more timely and relevant information to users about future cash flows. Explanation Users of financial information seek timely information about future cash flows. The accrual basis of accounting provides this information at the earliest appearance of objective evidence. Thus, accrual accounting provides more timely and relevant information to users. The cash basis is more concerned with recording cash flows for transactions that have already occurred. Accrual accounting (not cash-based accounting) necessitates the use of discretion because of the many estimates and judgments involved with assigning revenue and expense to the appropriate periods. (Module 12.2, LOS 12.f) Question #32 of 58 Question ID: 1472618 William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection with a potential investment recommendation of their common stocks. He is particularly concerned about the quality of each company's financial results in 2007–2008 and in developing projections for 2009 and 2010 fiscal years. Adams Company has been the largest company in the industry, but Jefferson Inc. has grown more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower domestic revenue growth for both companies. The 10-k reports showed overall sales growth of 6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in overseas business was particularly impressive. According to the company's 10-k report, Jefferson offered a sales incentive to overseas customers. For those customers accepting the special sales discount, Jefferson shipped products to specific warehouses in foreign ports rather than directly to those customers' facilities. In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the impact of overall accruals on earnings quality. He noted that Jefferson had instituted an accounting change in 2008. The economic life for new plant and equipment investments was determined to be five years longer than for previous investments. For Adams, he noted that the higher level of inventories at the end of 2008 might be cause for concern in light of a further slowdown expected in the U.S. economy in 2009. The accompanying table shows financial data for both companies' Form 10-k reports for 2006–2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and related expenses for both companies as well as cash collections and receivables comparisons. Inventory trends relative to sales and the number of days' sales outstanding in inventory were determined for both companies. Expense trends were examined for Adams and Jefferson relative to sales growth and accrual ratios on a balance sheet and cash flow basis were developed as overall measures of earnings quality. Adams Company ($ in thousands) Gross sales Sales discounts, returns, and allowances Net sales Jefferson Inc. 2006 2007 2008 2006 2007 2008 32,031 34,273 36,330 25,625 27,675 30,900 781 836 886 625 675 900 31,250 33,438 35,444 25,000 27,000 30,000 Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500 9,028 9,660 10,240 7,222 7,800 8,200 Depreciation expense 625 669 709 500 515 516 Interest expense 400 428 454 360 366 396 Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388 Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155 Net income 3,501 3,746 3,971 2,668 3,041 3,233 Dividends 3,000 3,180 3,307 2,460 2,760 2,880 501 566 664 208 281 353 150 160 170 120 130 120 250 325 345 200 217 195 15,875 16,758 17,763 12,700 13,000 15,892 6,500 6,850 7,800 5,200 5,200 4,500 8,562 8,991 9,440 6,850 7,057 7,200 31,337 33,084 35,518 25,070 25,604 27,907 7,062 7,880 9,300 6,050 6,100 6,398 337 400 450 270 373 1,525 Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600 Common stock 15,000 15,000 15,000 12,000 12,000 12,000 1,438 2,004 2,668 750 1,031 1,384 31,337 33,084 35,518 25,070 25,604 27,907 % change gross sales 7.0% 6.0% 8.0% 11.7% % change sales 6.0% 6.0% 8.0% 33.3% SG&A expenses Net addition to retained earnings Balance Sheet Cash and equivalents Short-term marketable securities Accounts receivable (net) Inventories PP&E (net of depreciation) Total assets Accounts payable Other current liabilities Retained earnings Total liabilities and shareholders equity discounts and allowances % change net sales 7.0% 6.0% 8.0% 11.1% 7.0% 6.0% 8.0% 17.0% 6.0% 6.0% 8.0% 5.1% 6.0% 6.0% 3.0% 0.2% 6.0% 6.0% 2.0% 22.3% 5.0% 13.8% 0.0% (13.5%) 1.03 1.03 1.03 1.0 1.0 1.1 155 153 164 144 143 106 3.4% 3.5% 3.9% 2.0% 2.4% 10.1% 3.4% 3.5% 3.8% 2.0% 2.0% 4.3% % change cost of goods sold % change in SG&A % change in depreciation expense % change in accounts receivable % change in inventories Revenues % cash collections Days inventory outstanding Balance sheet accrual ratio Cash flow accrual ratio Comparisons of expense trends in 2007–2008 showed: higher growth of Adams’s SG&A and depreciation expense versus Jefferson’s; A) the small change in Jefferson’s depreciation may relate to the change in depreciation lives, while the slower SG&A growth may reflect expense controls imposed to offset lower gross profit margins. higher growth of Adams’s SG&A and depreciation expense versus Jefferson’s B) may indicate more effective expense control by Jefferson in a slowing domestic economy. Jefferson’s management appeared to have managed SG&A and depreciation C) expenses more effectively than Adams’s; there was a small increase in Jefferson’s depreciation expense and slower growth in SG&A relative to the company’s previous year and compared to Adams’s trends. Explanation The more favorable trends in Jefferson's expenses may reflect more aggressive depreciation accounting and controls imposed on discretionary expenses to offset declining gross profit margins. (Module 12.1, LOS 12.b) Question #33 of 58 Question ID: 1472609 Duster Corporation's year-end income statement reported the following: Operating income $187,000 Results from discontinued operations: Loss from segment operations (net of $1,440 tax effect) ($2,160) Gain on segment disposal (net of $8,640 tax effect) 12,960 Gain on sale of equipment Interest expense 10,800 3,400 12,400 Extraordinary loss (net of $2,200 tax benefit) Income tax expense 3,300 71,200 Calculate Duster's income from continuing operations for the year. A) $100,200. B) $103,500. C) $106,800. Explanation Income from continuing operations includes all revenues and expenses except discontinued operations and extraordinary items: $187,000 operating income + $3,400 gain on sale of equipment – $12,400 interest expense – $71,200 income tax expense = $106,800. (Module 12.1, LOS 12.b) Question #34 of 58 Question ID: 1472602 Which of the following statements about cash flow is (are) CORRECT? Statement #1: Statement #2: The cash effects of decreasing accounts payable turnover are unlimited. The tax benefits from employee stock options can result in a significant source of investing cash flow. Statement #1 Statement #2 A) Correct Incorrect B) Incorrect Correct C) Incorrect Incorrect Explanation 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. (Module 12.1, LOS 12.b) Question #35 of 58 Question ID: 1472645 Which of the following is least likely an indicator of high-quality cash flow? A) OCF derived from sustainable sources. B) OCF adequate to cover capital expenditures, dividends and debt repayments. C) Total cash flow that is positive and high. Explanation High-quality cash flow focuses on positive, adequate and sustainable operating cash flow. Firms with high borrowings could have high total cash flow but such cash flows would not be sustainable (nor considered high-quality). (Module 12.4, LOS 12.l) Question #36 of 58 Question ID: 1472620 In the context of the Beneish model to evaluate the probability of earnings manipulation, an increase in Days Sales Receivable Index is least likely to signify: A) a decrease in probability of earnings manipulation. B) an increase in M-score. C) revenue inflation. Explanation An increase in Days Sales Receivable Index indicates revenue inflation and increases the M-score, thereby increasing the probability of earnings manipulation. (Module 12.2, LOS 12.c) Question #37 of 58 Question ID: 1472614 Which of the following statements about operating income and operating cash flow is most accurate? A) B) C) Operating income is confirmed by operating cash flow when the growth rates of the two measures are relatively stable over time. Operating income is more reliable than operating cash flow because of the judgments and estimates involved with accrual accounting. Operating cash flow usually increases faster than operating income when the firm is growing. Explanation When the growth rates of operating income and operating cash flow are stable over time, operating income is being confirmed by operating cash flow. Operating cash flow is more reliable than operating income. During growth, operating cash flow is usually lower than operating income as the firm uses cash to increase inventories and receivables. (Module 12.1, LOS 12.b) Question #38 of 58 Question ID: 1472643 William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection with a potential investment recommendation of their common stocks. He is particularly concerned about the quality of each company's financial results in 2007–2008 and in developing projections for 2009 and 2010 fiscal years. Adams Company has been the largest company in the industry, but Jefferson Inc. has grown more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower domestic revenue growth for both companies. The 10-k reports showed overall sales growth of 6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in overseas business was particularly impressive. According to the company's 10-k report, Jefferson offered a sales incentive to overseas customers. For those customers accepting the special sales discount, Jefferson shipped products to specific warehouses in foreign ports rather than directly to those customers' facilities. In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the impact of overall accruals on earnings quality. He noted that Jefferson had instituted an accounting change in 2008. The economic life for new plant and equipment investments was determined to be five years longer than for previous investments. For Adams, he noted that the higher level of inventories at the end of 2008 might be cause for concern in light of a further slowdown expected in the U.S. economy in 2009. The accompanying table shows financial data for both companies' Form 10-k reports for 2006–2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and related expenses for both companies as well as cash collections and receivables comparisons. Inventory trends relative to sales and the number of days' sales outstanding in inventory were determined for both companies. Expense trends were examined for Adams and Jefferson relative to sales growth and accrual ratios on a balance sheet and cash flow basis were developed as overall measures of earnings quality. Adams Company ($ in thousands) Gross sales Sales discounts, returns, and allowances Net sales Jefferson Inc. 2006 2007 2008 2006 2007 2008 32,031 34,273 36,330 25,625 27,675 30,900 781 836 886 625 675 900 31,250 33,438 35,444 25,000 27,000 30,000 Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500 9,028 9,660 10,240 7,222 7,800 8,200 Depreciation expense 625 669 709 500 515 516 Interest expense 400 428 454 360 366 396 Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388 Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155 Net income 3,501 3,746 3,971 2,668 3,041 3,233 Dividends 3,000 3,180 3,307 2,460 2,760 2,880 501 566 664 208 281 353 150 160 170 120 130 120 250 325 345 200 217 195 15,875 16,758 17,763 12,700 13,000 15,892 6,500 6,850 7,800 5,200 5,200 4,500 8,562 8,991 9,440 6,850 7,057 7,200 31,337 33,084 35,518 25,070 25,604 27,907 7,062 7,880 9,300 6,050 6,100 6,398 337 400 450 270 373 1,525 Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600 Common stock 15,000 15,000 15,000 12,000 12,000 12,000 1,438 2,004 2,668 750 1,031 1,384 31,337 33,084 35,518 25,070 25,604 27,907 % change gross sales 7.0% 6.0% 8.0% 11.7% % change sales 6.0% 6.0% 8.0% 33.3% SG&A expenses Net addition to retained earnings Balance Sheet Cash and equivalents Short-term marketable securities Accounts receivable (net) Inventories PP&E (net of depreciation) Total assets Accounts payable Other current liabilities Retained earnings Total liabilities and shareholders equity discounts and allowances % change net sales 7.0% 6.0% 8.0% 11.1% 7.0% 6.0% 8.0% 17.0% 6.0% 6.0% 8.0% 5.1% 6.0% 6.0% 3.0% 0.2% 6.0% 6.0% 2.0% 22.3% 5.0% 13.8% 0.0% (13.5%) 1.03 1.03 1.03 1.0 1.0 1.1 155 153 164 144 143 106 3.4% 3.5% 3.9% 2.0% 2.4% 10.1% 3.4% 3.5% 3.8% 2.0% 2.0% 4.3% % change cost of goods sold % change in SG&A % change in depreciation expense % change in accounts receivable % change in inventories Revenues % cash collections Days inventory outstanding Balance sheet accrual ratio Cash flow accrual ratio Based on the financial results of Adams and Jefferson in 2007 and 2008, the company demonstrating the lower earnings quality would be: Adams due to lower cash collection measures, possible inventory obsolescence A) related to higher 2008 inventories despite slowing customer demand, higher expense growth compared to Jefferson, and lower balance sheet and cash flow accrual ratios relative to Jefferson. Adams due to slower revenue growth, higher expense growth compared to B) Jefferson, possible inventory obsolescence related to higher 2008 inventories despite slowing customer demand, and lower balance sheet and cash flow based accrual ratios in 2008 compared to Jefferson. Jefferson due to sharply higher accruals ratios and less conservative accounting C) methods indicated by the change in depreciation policies and the impact of changes in shipment terms on revenue recognition and inventories for the special overseas offer. Explanation According to the simple measures of earnings quality, balance sheet, and cash flow accruals ratios, Jefferson's earnings quality in 2008 was lower than its 2007 levels and relative to Adams's. The more aggressive accounting treatment for the overseas special offer lowered the quality of revenues and may have understated inventories if some of these customers did not take delivery of the shipments. Jefferson also instituted a more liberal policy toward depreciable lives versus Adams, another indicator of lower earnings quality. (Module 12.3, LOS 12.h) Question #39 of 58 Question ID: 1472612 Galaxy Company recognized a restructuring charge in its year-end income statement. Similar restructuring charges have occurred in the past. In addition, Galaxy recognized an extraordinary loss. Galaxy uses the term "operational earnings" when discussing its financial results. According to Galaxy, "operational earnings" excludes special nonrecurring transactions such as restructuring charges, discontinued operations, and extraordinary items. Should the restructuring charge and extraordinary loss be included or excluded from "operational earnings" for analytical purposes? A) Both are included. B) One is included. C) Both are excluded. Explanation The restructuring charge does not appear to be nonrecurring; thus, it should be included in "operational earnings." By definition, an extraordinary loss is unusual in nature and infrequent in occurrence. Therefore, the extraordinary loss should be excluded from "operational earnings." (Module 12.1, LOS 12.b) Question #40 of 58 Sustainable earnings are most likely to be driven by: A) Conservative revenue recognition practices. B) Accruals element of earnings. C) Cash flow element of earnings. Explanation Question ID: 1472636 Sustainable and persistent earnings are driven by cash flow element of earnings. The stability and accuracy of earnings forecasts can be reduced by estimation process that generates the accruals component of earnings. Conservative and aggressive revenue recognition practices both would result in reversion in earnings (and hence lowers the sustainability of earnings). (Module 12.3, LOS 12.g) Question #41 of 58 Question ID: 1472626 Jeremy Jennings is explaining the concept of earnings quality to his new colleagues. Which of the following measures is most indicative of a higher quality of earnings when attempting to forecast future earnings? A) Higher level of earnings. B) Higher degree of conservatism of earnings. C) Higher degree of persistence of earnings. Explanation The term earnings quality usually refers to the persistence and sustainability of a firm's earnings; that is, more persistent and sustainable earnings are considered higher quality. Measuring earnings quality based on conservative earnings is an inferior measure when attempting to forecast future earnings because most accruals will self-correct over time. For example, the lower earnings that result from accelerated depreciation will increase in the later years of the asset's life. Focusing on accruals and deferrals is a more effective way of measuring earnings quality. A higher level of earnings has no impact on increasing the quality of earnings since the former may be derived largely from earnings manipulation on the part of management. (Module 12.2, LOS 12.f) Question #42 of 58 Question ID: 1472616 William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection with a potential investment recommendation of their common stocks. He is particularly concerned about the quality of each company's financial results in 2007–2008 and in developing projections for 2009 and 2010 fiscal years. Adams Company has been the largest company in the industry, but Jefferson Inc. has grown more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower domestic revenue growth for both companies. The 10-k reports showed overall sales growth of 6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in overseas business was particularly impressive. According to the company's 10-k report, Jefferson offered a sales incentive to overseas customers. For those customers accepting the special sales discount, Jefferson shipped products to specific warehouses in foreign ports rather than directly to those customers' facilities. In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the impact of overall accruals on earnings quality. He noted that Jefferson had instituted an accounting change in 2008. The economic life for new plant and equipment investments was determined to be five years longer than for previous investments. For Adams, he noted that the higher level of inventories at the end of 2008 might be cause for concern in light of a further slowdown expected in the U.S. economy in 2009. The accompanying table shows financial data for both companies' Form 10-k reports for 2006–2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and related expenses for both companies as well as cash collections and receivables comparisons. Inventory trends relative to sales and the number of days' sales outstanding in inventory were determined for both companies. Expense trends were examined for Adams and Jefferson relative to sales growth and accrual ratios on a balance sheet and cash flow basis were developed as overall measures of earnings quality. Adams Company ($ in thousands) Gross sales Sales discounts, returns, and allowances Net sales Jefferson Inc. 2006 2007 2008 2006 2007 2008 32,031 34,273 36,330 25,625 27,675 30,900 781 836 886 625 675 900 31,250 33,438 35,444 25,000 27,000 30,000 Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500 9,028 9,660 10,240 7,222 7,800 8,200 Depreciation expense 625 669 709 500 515 516 Interest expense 400 428 454 360 366 396 Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388 Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155 Net income 3,501 3,746 3,971 2,668 3,041 3,233 Dividends 3,000 3,180 3,307 2,460 2,760 2,880 501 566 664 208 281 353 150 160 170 120 130 120 250 325 345 200 217 195 15,875 16,758 17,763 12,700 13,000 15,892 6,500 6,850 7,800 5,200 5,200 4,500 8,562 8,991 9,440 6,850 7,057 7,200 31,337 33,084 35,518 25,070 25,604 27,907 7,062 7,880 9,300 6,050 6,100 6,398 337 400 450 270 373 1,525 Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600 Common stock 15,000 15,000 15,000 12,000 12,000 12,000 1,438 2,004 2,668 750 1,031 1,384 31,337 33,084 35,518 25,070 25,604 27,907 % change gross sales 7.0% 6.0% 8.0% 11.7% % change sales 6.0% 6.0% 8.0% 33.3% SG&A expenses Net addition to retained earnings Balance Sheet Cash and equivalents Short-term marketable securities Accounts receivable (net) Inventories PP&E (net of depreciation) Total assets Accounts payable Other current liabilities Retained earnings Total liabilities and shareholders' equity discounts and allowances % change net sales 7.0% 6.0% 8.0% 11.1% 7.0% 6.0% 8.0% 17.0% 6.0% 6.0% 8.0% 5.1% 6.0% 6.0% 3.0% 0.2% 6.0% 6.0% 2.0% 22.3% 5.0% 13.8% 0.0% (13.5%) 1.03 1.03 1.03 1.0 1.0 1.1 155 153 164 144 143 106 3.4% 3.5% 3.9% 2.0% 2.4% 10.1% 3.4% 3.5% 3.8% 2.0% 2.0% 4.3% % change cost of goods sold % change in SG&A % change in depreciation expense % change in accounts receivable % change in inventories Revenues % cash collections Days inventory outstanding Balance sheet accrual ratio Cash flow accrual ratio Jones observed that comparisons of 2007–2008 trends in sales, accounts receivables, and cash collections showed: Jefferson’s higher increase in sales relative to Adams’s led to improvement in A) cash collections indicated by the rise in the revenue/collections ratio. There was no change in Adams’s cash collections in 2008. Jefferson’s decline in cash and equivalents in 2008 resulted in lower cash B) collections despite strong sales growth; Adams’s showed similar growth in cash and equivalents and accounts receivable relative to sales gains. Jefferson’s sales growth accelerated in 2008 compared to Adams’s, but cash C) collections declined as indicated by the rise in receivables and the revenue/collections ratio; Adams’s sales, accounts receivables, and cash collections rose at similar rates in 2008. Explanation The increase in Jefferson's revenues relative to cash collections along with the large increase in accounts receivable indicates declining cash collections in 2008 compared to its experience in 2007 and relative to Adams's, which showed consistency in both years. (Module 12.1, LOS 12.b) Question #43 of 58 Question ID: 1472601 Marcel Schulte is analyzing various retailing firms. Which of the following items is least indicative of a potential problem with revenue recognition and earnings quality? A) Implementing a “bill and hold” arrangement. B) Disproportionate revenues in the last quarter of the calendar year. C) Use of barter transactions. Explanation Disproportionate revenues in the last quarter may be an indication of aggressive revenue recognition to meet analyst forecasts but it is much more likely if the firm is a nonseasonal one. A retailing firm presumably has a disproportionate amount of sales during the busy Christmas season in the last quarter of the calendar year so this point alone would not be indicative of a potential problem. In a barter transaction, two parties exchange goods or services. The main issue is whether: (a) a sale transaction has actually occurred in substance; (b) it is not a "sham" transaction; and (c) the transaction amount is overstated. Bill and hold occurs when the retailer (seller) invoices the customer but does not ship the goods until a later date. Alternatively, the seller may ship the goods to a location other than the customer's. In either case, the seller may be recognizing revenue prematurely. (Module 12.1, LOS 12.b) Question #44 of 58 High results quality is most likely demonstrated by: A) GAAP compliant financial reports that are decision useful. B) an adequate level of return that is sustainable. C) high level of earnings determined conservatively. Explanation Question ID: 1472595 High results quality occurs if the level of earnings provides an adequate level of return and that the earnings are sustainable. (Module 12.1, LOS 12.a) Question #45 of 58 Question ID: 1472619 William Jones, CFA, is analyzing the financial performance of two U.S. competitors in connection with a potential investment recommendation of their common stocks. He is particularly concerned about the quality of each company's financial results in 2007– 2008 and in developing projections for 2009 and 2010 fiscal years. Adams Company has been the largest company in the industry, but Jefferson Inc. has grown more rapidly in recent years. Adams's net sales in 2004 were 33-1/3% higher than Jefferson's but were only 18% above Jefferson's in 2008. During 2008, a slowing U.S. economy led to lower domestic revenue growth for both companies. The 10-k reports showed overall sales growth of 6% for Adams in 2008 compared to 7% for 2007 and 9% in 2006. Jefferson's gross sales rose almost 12% in 2008 versus 8% in 2007 and 10% in 2006. In the past three years, Jefferson has expanded its foreign business at a faster pace than Adams. In 2008, Jefferson's growth in overseas business was particularly impressive. According to the company's 10-k report, Jefferson offered a sales incentive to overseas customers. For those customers accepting the special sales discount, Jefferson shipped products to specific warehouses in foreign ports rather than directly to those customers' facilities. In his initial review of Adams's and Jefferson's financial statements, Jones was concerned about the quality of the growth in Jefferson's sales, considerably higher accounts receivables, and the impact of overall accruals on earnings quality. He noted that Jefferson had instituted an accounting change in 2008. The economic life for new plant and equipment investments was determined to be five years longer than for previous investments. For Adams, he noted that the higher level of inventories at the end of 2008 might be cause for concern in light of a further slowdown expected in the U.S. economy in 2009. The accompanying table shows financial data for both companies' Form 10-k reports for 2006–2008 used by Jones for his analysis. To evaluate sales quality, he focused on trends in sales and related expenses for both companies as well as cash collections and receivables comparisons. Inventory trends relative to sales and the number of days' sales outstanding in inventory were determined for both companies. Expense trends were examined for Adams and Jefferson relative to sales growth and accrual ratios on a balance sheet and cash flow basis were developed as overall measures of earnings quality. Adams Company ($ in thousands) Gross sales Sales discounts, returns, and allowances Net sales Jefferson Inc. 2006 2007 2008 2006 2007 2008 32,031 34,273 36,330 25,625 27,675 30,900 781 836 886 625 675 900 31,250 33,438 35,444 25,000 27,000 30,000 Cost of goods sold 15,312 16,384 17,367 12,250 13,250 15,500 9,028 9,660 10,240 7,222 7,800 8,200 Depreciation expense 625 669 709 500 515 516 Interest expense 400 428 454 360 366 396 Income before taxes 5,835 6,243 6,618 4,668 5,069 5,388 Taxes (tax rate 40%) 2,334 2,497 2,647 2,000 2,028 2,155 Net income 3,501 3,746 3,971 2,668 3,041 3,233 Dividends 3,000 3,180 3,307 2,460 2,760 2,880 501 566 664 208 281 353 150 160 170 120 130 120 250 325 345 200 217 195 15,875 16,758 17,763 12,700 13,000 15,892 6,500 6,850 7,800 5,200 5,200 4,500 8,562 8,991 9,440 6,850 7,057 7,200 31,337 33,084 35,518 25,070 25,604 27,907 7,062 7,880 9,300 6,050 6,100 6,398 337 400 450 270 373 1,525 Long-term debt 7,500 7,800 8,100 6,000 6,100 6,600 Common stock 15,000 15,000 15,000 12,000 12,000 12,000 1,438 2,004 2,668 750 1,031 1,384 31,337 33,084 35,518 25,070 25,604 27,907 % change gross sales 7.0% 6.0% 8.0% 11.7% % change sales 6.0% 6.0% 8.0% 33.3% SG&A expenses Net addition to retained earnings Balance Sheet Cash and equivalents Short-term marketable securities Accounts receivable (net) Inventories PP&E (net of depreciation) Total assets Accounts payable Other current liabilities Retained earnings Total liabilities and shareholders equity discounts and allowances % change net sales 7.0% 6.0% 8.0% 11.1% 7.0% 6.0% 8.0% 17.0% 6.0% 6.0% 8.0% 5.1% 6.0% 6.0% 3.0% 0.2% 6.0% 6.0% 2.0% 22.3% 5.0% 13.8% 0.0% (13.5%) 1.03 1.03 1.03 1.0 1.0 1.1 155 153 164 144 143 106 3.4% 3.5% 3.9% 2.0% 2.4% 10.1% 3.4% 3.5% 3.8% 2.0% 2.0% 4.3% % change cost of goods sold % change in SG&A % change in depreciation expense % change in accounts receivable % change in inventories Revenues % cash collections Days inventory outstanding Balance sheet accrual ratio Cash flow accrual ratio The quality of earnings as measured by balance-sheet-based accruals ratios showed: strong improvement in Jefferson’s earnings quality relative to Adams’s due to A) the sharp jump in the ratio in 2008 compared to the much smaller increase for Adams. B) C) both companies’ earnings quality improved due to the increase in the ratio with Jefferson showing the most improvement. decrease in Jefferson’s earnings quality relative to Adams’s due to the sharp jump in the ratio in 2008 compared to a much smaller increase for Adams. Explanation The lower the ratio, the higher will be the earnings quality. Jefferson's ratio rose sharply in 2008 compared to the previous years and was substantially above Adams's. Thus, Jefferson's earnings quality is lower. (Module 12.1, LOS 12.b) Question #46 of 58 Question ID: 1472646 Samuel Maskin, CFA is evaluating the financial statements of Northern Energy Inc. The following is an extract from Northern's cash flow statement for the past three years: 20x6 20x5 20x4 Net Income $1,023 $988 $744 Depreciation $187 $145 $128 Restructuring Charges $(108) $(104) $212 Accounts receivable $(172) $(145) $(33) Inventories $(418) $(202) $(180) Accounts Payable $38 $37 $33 OCF $550 $719 $904 Which of the following conclusions is least likely for Northern? A) Northern is stretching payables. B) Days sales outstanding is probably increasing. C) Northern may have accelerated revenue recognition. Explanation We are not provided with income statement data such as revenues and COGS and hence have to make inferences from the information provided. Accounts payable seem to be stable and decreasing as a percentage of net income making the conclusion of stretching payables least likely. Revenue acceleration can be concluded based on large increase in inventory in 20x6 (possibly reflecting returns from customers) combined with increases in accounts receivable over time. Increases in accounts receivable (relative to earnings) also would indicate that days sales outstanding would most likely be increasing. (Module 12.4, LOS 12.i) Question #47 of 58 Question ID: 1472610 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) An increasing days’ inventory on hand (DOH) measure may be indicative of obsolete inventory. B) C) Negative nonrecurring or non-operating items may be indicative of misclassifying an operating expense. A decreasing days’ sales outstanding (DSO) measure may be an indication of lower quality revenue. Explanation 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. (Module 12.1, LOS 12.b) Question #48 of 58 Question ID: 1472625 Complete the following sentence. An analyst would apply _________ to the cash component of income compared to the accrual component when evaluating company performance. A) the same weighting. B) a higher weighting. C) a lower weighting. Explanation Since the cash component has more sustainability in the future than the accrual component, an analyst would apply a higher weighting to the cash component of income than the accrual component when evaluating company performance. (Module 12.2, LOS 12.f) Question #49 of 58 Question ID: 1472622 Brent Jones, CFA is analyzing the financial statements of Imperial Resorts Inc. Jones wants to use the Beneish model to evaluate the probability of earnings manipulation. Jones makes the following statements: 1. Depreciation index of less than 1 would indicate that the company is depreciating assets at a higher rate than its peers. 2. Increases in Asset quality index indicate that the revenue recognition policies are conservative. Regarding the statements by Jones: A) Only statement 2 is correct. B) Only statement 1 is correct. C) None of the statements is correct. Explanation Statement 1 is incorrect. Depreciation index less than 1 indicates that the company is depreciating assets at a higher rate than in prior years (and not relative to its peers). Statement 2 is incorrect. Asset quality index is used as an indicator of excessive capitalization of expenses. (Module 12.2, LOS 12.d) Question #50 of 58 Question ID: 1472606 Charles Nicholls, chief investment officer of Gertmann Money Management, is reviewing the year-end financial statements of Zartner Canneries. In those statements he sees a sharp increase in inventories well above the sales-growth rate, and an increase in the discount rate for its pension liabilities. To determine whether or not Zartner Canneries is cooking the books, what should Nicholls do? A) Check Zartner’s cash-flow statement and review its footnotes. B) Analyze trends in Zartner’s receivables and consider the changing characteristics of its work force. C) Calculate Zartner’s turnover ratios and review the footnotes of its competitors. Explanation To assess the meaning of the inventory increase, look for declines in inventory turnover. And if Zartner changes its pension assumptions, Nicholls should see how those new assumptions compare to those found in the footnotes of financial statements from other companies in the same industry. (Module 12.1, LOS 12.b) Question #51 of 58 Question ID: 1472631 Classification shifting is least likely to result in a higher: A) firm value derived when cash flow forecasts are based on core earnings. B) reported net income. C) equity value derived when earnings forecasts are based on operating earnings. Explanation Classification shifting results in inflation of core or recurring earnings while keeping the total reported income same. This is used to mislead analysts into using a higher number as a basis for generating forecasts of future earnings and cash flows. Such erroneous forecasts would then result in inflated equity and firm valuation. (Module 12.2, LOS 12.e) Question #52 of 58 Question ID: 1472596 To assess the quality of financial reports, which question is least necessary for an analyst to answer? A) Are reported earnings consistent with the firm’s budget? B) Are the financial reports decision useful and GAAP compliant? C) Do earnings represent an adequate level of return? Explanation Quality of financial reports is assessed by answering two questions: Whether the financial reports are decision useful and GAAP compliant and whether the results quality is high (i.e., earnings provide adequate return on capital and are sustainable). (Module 12.1, LOS 12.a) Question #53 of 58 Question ID: 1472635 Alex Fisher, CFA, is examining the phenomenon of mean reversion on the earnings of several firms. Which of the following statements regarding mean reversion is least accurate? A) High earnings should not be expected to continue indefinitely. B) Normal earnings should not be expected to continue indefinitely. C) Low earnings should not be expected to continue indefinitely. Explanation When examining net income, analysts should be aware that earnings at extreme levels tend to revert back to normal levels over time. This phenomenon is known as mean reversion. As a result of mean reversion, analysts must understand that extreme earnings (high or low) should not be expected to continue indefinitely. (Module 12.3, LOS 12.g) Question #54 of 58 Question ID: 1472598 Aggressive revenue recognition practices are least likely to increase: A) reported assets B) reported expenses C) reported ending inventory Explanation Aggressive revenue recognition practices would increase accounts receivable, revenues, expenses, income and stockholder's equity. Ending inventory would decline but by less than the increase in accounts receivable resulting in increase in total assets. Early recognition of revenues also accelerates recognition of expenses (COGS). (Module 12.1, LOS 12.b) Question #55 of 58 Question ID: 1472603 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) Ignoring cash flow. B) Misclassifying cash flow. C) Managing cash flow. Explanation 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. (Module 12.1, LOS 12.b) Question #56 of 58 Question ID: 1472632 Which one of the following choices is least likely to be an indicator of poor-quality earnings? A) Restatement of previously issued financial statements. B) Reported earnings handily beat analyst estimates. C) An investigation by the market regulatory authority is initiated. Explanation Enforcement actions by regulatory authorities and restatements of previously issued financial statements are two (external) indicators of poor-quality earnings. Earnings that meet or narrowly beat analyst estimates are considered to be suspect for poor quality. Handily beating analyst estimates is not considered to be an indicator of poor-quality earnings. (Module 12.2, LOS 12.e) Question #57 of 58 Question ID: 1472647 Samuel Maskin, CFA is evaluating the financial statements of Northern Energy Inc. The following is an extract from Northern's cash flow statement for the past three years: 20x6 20x5 20x4 Net Income $1,023 $988 $744 Depreciation $187 $145 $128 Restructuring Charges $(108) $(104) $212 Accounts receivable $(172) $(145) $(33) Inventories $(418) $(202) $(180) Accounts Payable $38 $37 $33 OCF $550 $719 $904 The restructuring charges for Northern has most likely: A) B) C) Increased reported earnings for 20x4 while reducing reported earnings in 20x5 and 20x6. Increased reported earnings in 20x6 while reducing reported earnings in 20x4 and 20x5. Reduced reported earnings in 20x4 while increasing reported earnings in 20x5 and 20x6. Explanation Restructuring charges contribute positively to 20x4 cash flow indicating that it was a noncash charge against that year's income. In the following two years, there is a reversal of that charge leading to an artificial increase in reported earnings for 20x5 and 20x6. (Module 12.4, LOS 12.i) Question #58 of 58 Question ID: 1472608 Analyst Jane Kilgore is worried that some of Maxwell Research's accrual accounting practices will lead to excessive operating earnings recognition in the near-term. Examples of Kilgore's concerns include the following: Accelerated revenue recognition of service agreements. Classification of recurring revenue as nonrecurring revenue. Understated inventory obsolescence. Which of Kilgore's concerns is least likely to overstate current operating earnings? A) Understated inventory obsolescence. B) Accelerated revenue recognition of service agreements. C) Classification of recurring revenue as nonrecurring revenue. Explanation Classification of recurring revenue as nonrecurring revenue will understate current operating earnings. The other two items act to overstate revenue and understate expenses. (Module 12.1, LOS 12.b)